By Kyle Tetting

Stock investors have grown accustomed to the market’s occasional tantrums. A disappointing headline, unexpected news on the trade war or a weak economic report can turn an otherwise good day for stocks into a bad one. And with constant coverage of the markets, the cause of the latest decline is easy to pinpoint: Just ask any of the experts on TV.

Of course, the longer-term view—what really matters to investors in the end—has little to do with the latest headline. The long term relies on demographic shifts, technology changes, monetary policy, fiscal policy and expectations of where we’ve been and where we’re going. Unfortunately for investors, no single headline will tell us what we need to know.

When we see the headline “U.S. manufacturing is in a recession,” we wonder how quickly a factory downturn will spill over into the rest of the economy and then how quickly it will cause a drop in our portfolios.

Fortunately, what might previously have spread quickly to the economy and markets should be more subdued as manufacturing is a smaller part of employment and the broader economy. While its declines will be felt, manufacturing alone is unlikely to disrupt our current slow growth environment.

Many investors see the ghosts of past weakness at every turn. We’ve come to expect the worst as a result of the severe bear market that accompanied the Great Recession. In many ways, the slow growth of the last decade resulted from a constant expectation that the next shoe could drop at any time. Still spooked by the last downturn, banks held back from lending and corporations from spending. Consumers too cut back, allowing many households to slowly recover.

Transparency around the fallibility of stocks and the economy, gleaned from the depths of the Great Recession, may make the next downturn less severe.

Extreme valuations, which accompanied so many of the past economic recessions and market declines, are not a problem at present. With a trailing price-earnings ratio of 17.9, the S&P 500 trades at just a 3.5% premium to the 20-year average, which is below post Great Recession peaks and well below other periods of elevated valuations. As stocks have run higher, investors have broadly pulled back, unwilling to support stretched valuations in anticipation of a slowdown.

More articles and videos from Kyle Tetting on Money Talk

An overly aggressive Federal Reserve also accompanied many of the past recessions and market downturns. But this time, so far, the Fed is taking a more cautious approach. As initial signs of weakness emerged, the Fed flipped from tightening monetary policy to loosening it. The about-face is unlikely to have an immediate impact on the economy, but it does turn a headwind into a tailwind.

While typical triggers appear unlikely to cause the next recession, there is no doubt that the U.S. economy has been slowing. Some of the slowdown is attributed to the cyclical nature of the economy, but it is also a result of a prolonged period of stagnant global growth, which has finally caught up with the U.S.

There is good news for investors, even if the trend of slowing economic growth continues. Significant market corrections tend to accompany periods of slowing, but the long-running expectation of weakness should help limit the decline in the next recession. Already prepared for the worst, investors will be less likely to run to safety in the next decline.

History also suggests that the next decline in stocks may be less severe. Recessions and stock market declines in the 1940s, ‘50s and ‘60s were historically mild, especially following the struggles of those who lived through the Great Depression. In part, and as studies have pointed out, the experiences of those who were born into or lived through the Depression had a lasting impact on risk-taking later on. In turn, a reduced appetite for risk led to more grounded expectations for stocks and fewer overextended investors.

As evidenced by less risky bank lending, stockpiles of cash on corporate balance sheets and reduced household debt service liabilities, the U.S. economy is much less leveraged than it was prior to the last downturn. That won’t stop the decline, but it should help limit the magnitude and shorten the duration.

Finally, with the experiences of the Great Recession still fresh, investors are planning how to respond to the next one. We now know from history and experience what a steep downturn looks like and how to better navigate the pitfalls. As we watch for further signs of slowdown, now is the time to formulate a plan, including:

• Anticipate cash needs years into the future, and set aside that amount in funds that are reasonably expected to hold up. We all prefer the returns of stocks over high-quality bonds in up markets, but there is a place for bonds in a portfolio.
• Re-evaluate unintended risks and act accordingly. If the strong run in stocks, especially growth stocks, has allowed allocations to grow, now may be the time to rebalance. The rebalancing is not a response to the current environment but rather a response to the overweight resulting from strong performance.
• Have a candid conversation about tolerances for risk. It might feel good at the time to jump into and out of the market based on emotion, but each move requires you to be right twice: Once, by selling before markets get bad and a second time, by buying back in before prices have recovered. Instead, try to find a level of risk that seems right, and allocate accordingly.

No single headline will point to the start of the next downturn. But as the slow growth continues, we’re planning with the expectation that this one won’t be like the last.

Kyle Tetting is director of research and an investment advisor at Landaas & Company.

Learn more
Fed’s about-face, interest rates, earnings, a Money Talk Video with Bob Landaas and Marc Amateis
Ignore bonds at your own risk, a Money Talk Video with Kyle Tetting
When Should I …rebalance my portfolio? by Art Rothschild
Risk: How much can you stand? How much do you need, a Money Talk Video with Isabelle Wiemero
Historic economic growth vs. long-term investing, by Joel Dresang
Crash test dummies, by Joel Dresang

(initially posted October 24, 2019)

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