Market Perspective
Timing the Economy: A Very Dangerous Game
OCTOBER 17, 2008
Ernie Ankrim,
Chief Investment
Strategist
The National Bureau of Economic Research’s (NBER’s) Business Cycle
Dating Committee identifies the beginning and ending dates of U.S.
Recessions. Although we have yet to hear from them on an official date
for the start of a new recession, there is little doubt in my or my
colleagues’ minds that we are in one. You may think that this should
lead to a recommendation to sell stocks until a healthy economy is once
again in place. I strongly recommend against jumping to that
conclusion.
Attempting to time your exit from and re-entry into the stock market based on the
perceived state of the economy offers small chance of adding value to your portfolio
unless you possess amazing skills in foretelling these beginning and ending dates. Most of
us (yours truly included), just can’t do it. In fact, if history is any guide at all, the best
buying and selling times around recessions are most likely to be points in which the data
are unclear at best and, in most cases, dramatically misleading.
THE LAGGED DATA & ANALYSIS FACTOR
The NBER looks at data on personal incomes, employment, industrial production, sales
and estimates of changes in GDP to determine the level of economic activity that leads to
identifying turning points in the economy. But even they don’t have sufficient evidence to
identify these points until after some time has passed. They didn’t identify the last
recession’s starting point, March 2001, until eight months later (November 2001). The
committee took 20 months to determine that the recession ended in November 2001,
making its announcement in July 2003. So, although my colleagues and I believe a
recession started months ago (and I’d guess that most Americans share those
sentiments), nobody knows. And we won’t know for sure until we hear it from the NBER
some time in the future.
Now, consider this: Even if you could intuit those economic turning points, you’re likely to
miss the best times to change your equity allocation, because the market and the
economy move in different phases.
A BRIEF HISTORY OF RECESSIONS
Since 1953-54, the U.S. has experienced nine recessions not counting the one we’re
probably in now. That, by the way, isn’t cause for undue alarm. Recessions are part of the
economic cycle. The federal government can try to shorten recessions and decrease their
severity, but it can’t make them go away. Investors must learn to live with that.
Those nine recessions averaged 10.3 months in duration. Two recessions (1973-75 and
1981-82) lasted sixteen months. (The recession that kicked off the Great Depression
Russell Investments // Timing the Economy: A Very Dangerous Game
lasted 43 months.) The shortest “recent” recession (1980) lasted only six months. The last
recession (2001), as I mentioned, was eight months in duration.
So let’s see what would have happened if you’d been able to time the economy—to
identify the peaks (booms) and troughs (busts).
SURPRISING PERIODS OF BEST RETURNS
I gathered two sets of data. The return data in these tables is index data. While they can’t
be invested in directly, indexes tend to be good proxies for the market. The top row of
numbers represents the months until the peak or trough or the months following the peak
or trough for each of the nine most recent recessions listed at left. The first looks at when it
might have been best to get out of the market heading into a recession.
Following 12-month returns (%)
(months until Peak)
Return data sources: Ibbotson & Associates Equity Index 1952 – Jan. 1962 , S&P 500 Feb. 1962 – 2002
The second examines when it would have been best to get in heading out of a recession.
Following 12-month returns (%)
(months until Trough)
Return data sources: Ibbotson & Associates Equity Index 1952 – Jan. 1962 , S&P 500 Feb. 1962 – 2002
Admittedly, this data provides a lot of detail, but the few following examples should prove
enlightening.
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Let’s say you saw the country slipping into recession and wanted to sell, getting out of the
market at the economy’s peak. If you correctly identified that peak over the nine most
recent recessions ending in 2001, your average return for the twelve months following
each peak was 7.3%. Not bad, although it’s below the market’s historic annual average
gain of around 11%. But you could have done better!
If you waited for six months past the peak before getting out, your average annual return
for the next 12 months was 23.9%. That’s more than double the average.
How about getting back into the market as we headed out of a recession? If you bought in
at the trough—the low point of the economy—your average return for 12 months following
was 17.6%. Very good. But if you got back in six months before the trough—while the
economy was still heading down—your average return for the following 12 months was
27.8%. Much better!
This, I grant you, doesn’t seem logical. But it is. Here’s the explanation.
EYEING THE FUTURE
In the aggregate, investors certainly pay attention to how the economy is doing today.
However, they buy and sell based on how they think it will do tomorrow—or more
accurately, over the coming months. Anticipating a downturn in the future, they sell well
before they think the economy has peaked. As a result, the market usually falls well before
the economy does.
Conversely, they buy well before the economy hits bottom based on expectations of a
rebound and a brighter future. That’s why the market generally bounces back before the
economy does.
THE ANTI-ACID APPROACH
If I’ve learned one thing during my decades of research, it’s this: No one can precisely time
the economy or the market. Not you. Not me. Not anyone. If we react to prevailing
recession indicators, such as rising unemployment and declining profits, we’re just as likely
to exit and enter late. We’ll suffer the downside before getting out and miss the upside
before getting back in. In tough economic times such behavior is understandable.
Unfortunately, it damages our investment performance.
So what’s an investor to do? Make a plan and stick with it. Good financial planning takes
into account the long-term ups and downs of the economy and the market. Your plan can
keep you from taking drastic, and possibly disastrous, steps.
Then, maintain a steady course. Understand that equities’ average annual return of 11%
beats inflation handily and builds a nice portfolio for your later years.
Finally, there’s a big upside to not being able to time the economy—and not wanting to.
With a plan in place and ignoring as much of the scary or euphoric news as possible, you
may be able to sleep more soundly while other investors stay awake trying to figure out
their next nerve-wracking move.
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These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the
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