Financial Fear Factor

Well, the proverbial cat is out of the bag. Earlier this week the National Bureau of Economics (NBER) weighed in on the U.S. economic activity. The seven-member panel, which constitutes a veritable “Who’s Who” of economic academics issued its verdict that, according to its defining parameters, the U.S. economy is in recession and has been since December 2007.

According to the NBER report, “The committee considers a range of indicators of economic activity, and many of them suggest declining activity in the first quarter of the current calendar year.  These include payroll employment and the income-side estimates of domestic production”, otherwise known as unemployment and GDP.

The NBER’s confirmation of what many have long-suspected has made for a continuation of the topsy-turvy market climate that we have come to know—but not love.

Like few other words, the term “recession” can evoke a sense of fear for investors. Indeed, it is the lack of clarity of what’s ahead that prompts investors to worry about how deep the recession might be and how long it will last. It is important to remember, however, that this very uncertainty has been factored into market prices, facilitating the  market decline that has pushed prices down to compensate buyers with an expected return that remains about the same as it was before fear took root. In other words, the free market is doing its job as buyers and sellers agree upon prices that continue to reflect the uncertainty of expected returns.

That short investing lesson is accurate, but is it enough to rejoin the frayed nerves of investors who are just plain sick of the financial and emotional roller coaster? Maybe, maybe not.

We have no way of fast-forwarding to know how severe or how long this current recession may be. But, we do have significant data on recessions that give historical insight as to the depth and duration of every recession that was dealt our predecessors. Let’s take a look at what history shows.

With information provided by NBER, the table below details the duration, depth and diffusion across industries of each U.S. recession dating back to January 1920. As the table clearly indicates, the depth and duration of recessionary periods since 1938 has waned significantly as impact on employment, decline in GNP (gross national product) and duration of recessions have all decreased since the depression that ended in 1938.

The bar chart below contains additional data compiled from NBER. It details the duration of every economic recession (contraction) and expansion period dating back to August 1929 with the current expansion period which ended in December 2007.  The light green bars depict the duration periods (in months) of expansion, while the black bars depict the duration period (also in months) of recession or contraction. As you can see, over the last 80 years, the duration of expansion periods has increased, while the duration of recessionary periods has decreased.
 

Geoffrey Moore is the director emeritus of the Center for International Business Cycle Research at Columbia University. In his 2002 white paper titled “Recessions”(see footnote), Moore details a number of reasons for the trend of recessions decreasing in both duration and depth. He cites the growing importance of service industries like trade and transportation, which have more stable unemployment numbers than those of manufacturing. He states, “As the more stable industries have grown in importance, this has made the whole economy more stable and less susceptible to prolonged and severe recessions.”

Moore also credits the government for assuming a bigger role in the moderation of recessions, citing the infusion of unemployment insurance to stem the tide of lost income during downturns as well as assertive monetary policy which can make a more interest-rate friendly environment and free up much-needed credit during downturns.

It is important to understand that no two recessions are the same, and we have no way of predicting what shape the current recession will take, but we do know that fear has been a poor predictor of outcome.

An October 17, 1974 New York Times article cited a Gallup Poll in which 51% of individuals surveyed agreed with economists who had then predicted a “1930-style depression.”

At this time, the markets had experienced a steep 2-year decline, fear was rampant, and confidence was scarce. However, less than three months subsequent to this overwhelmingly gloomy prediction, the markets staged a vigorous and sustained upturn..

The chart below depicts the simulated performance of IFA’s all-equity Index Portfolio 100 for the time period from October 1974 through September 1979. As the chart shows, this blend of globally diversified indexes delivered an annualized return of 29.56% for the five-year period, with a total return of nearly 265%. Clearly, those investors who were led by fear were surprised and likely disappointed by missing out on some (if not all) of those significant returns.

The current headlines are filled with prognostications of how events will unfold, and there is certainly no shortage of opinions. IFA holds to a strict discipline of letting history guide our investing path. We do so because investment strategies that are driven by fear and speculation have shown to deliver inferior returns when compared with a straightforward asset class indexing strategy that carries 80 years of historical data. Reams of stock market data continue to show that buying and holding a risk-appropriate portfolio of low-cost, passively managed indexes has shown to be an excellent investing strategy—one you should never have to fear.