It’s been more than ten years since the end of the last recession, which is one of the reasons people have been talking about it lately. Historically, recessions come along every 5-7 years, and so by that measure, we’re overdue for one. On the other hand, forecasts of when the next recession will begin are notoriously unreliable. Just what is a recession and what it will mean when the next one comes around?
What is a recession?
A recession is a period when economic activity shrinks instead of increasing. As the population grows and technology and education make people more productive, there is a general trend for economies to expand. During a recession, some people stop working, factories produce fewer goods and economic activity contracts. In the past, recessions have been caused because of overproduction in some sector of the economy, leading to that sector halting production and laying off workers. This would ripple through other sectors and cause the entire economy to shrink.
Can One Predict a Recession?
Even the best economic forecasters only get about 40% of their calls right, so clearly there isn’t a reliable crystal ball when it comes to predicting something as complex as the economy. Still, we all try because it has major implications for saving, spending and investing. I’ve written in the past about interest rates and the predictive ability of the Treasury Yield Curve, but there are a host of other leading economic indicators. These include the length of the workweek, unemployment claims, credit conditions and even the change in the S&P 500 index.
An organization known as the Conference Board prepares an Index of Leading Economic Indicators which includes these and other components. This index tends to turn negative about a year before a recession begins. Currently, it’s flat (unchanged from previous readings) and hasn’t actually begun to fall yet.
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Is a Recession Likely?
The next recession is not only likely – it’s a certainty. Recessions are part of the regular business cycle. Before World War II, these periods of boom and bust were much more pronounced with stronger growth and deeper recessions. Since then, economic growth has moderated somewhat and become more predictable, but growth is still cyclical, and a recession will definitely happen again. Deep recessions like the last one are thankfully rare, and the next one is unlikely to be as bad as the last.
What does a recession mean for my finances?
When a recession hits, the value of stocks (and the companies they represent) typically fall, because they won’t be making as much money as investors had been expecting. Job losses may also impact your income.
Having a financial plan prepares you for both the ups and downs of the economy and should be developed with alternate scenarios in mind. By first articulating and quantifying your goals, you will have an idea of what it will take to achieve them. A good plan will have considered the possibility of recessions and will have flexibility built into its design. For example, a recession increases the possibility of job losses and layoffs. A good plan would provide for emergency funds set aside in case something like this happened.
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A good financial plan should also rely on modest returns to achieve your goals and should be stress-tested to ensure that it works under a variety of circumstances. If your plan only succeeds by earning 12% per year on your investments, that’s not very realistic and will probably fail when a recession takes a bite out of your savings. On the other hand, if you can achieve your goals while earning more modest returns, then one or two bad years in between the good ones shouldn’t knock you off-track.
Since recessions are guaranteed to happen, you’re better off with a well-diversified all-weather portfolio that can withstand the ups and downs of the stock market, rather than trying to time short-term changes in your investments to match the market’s mood swings. This kind of market timing is very difficult to achieve, and for most investors it hurts more than it helps.
At Blankinship & Foster, we design investment plans that integrate with your financial plan, so that you will always be prepared for short term cash needs as well as funding your long-term goals. We call it Investing With Purpose. Contact us to learn more about how we can help you invest with purpose.
