How to Minimize the Impact of Inflation, Recessions, and Stock Market Crashes
Investors fear “Stock Market Corrections” and often equate them to “Economic Recessions”, but as you’ll read in this article, the two are not the same. In fact one can occur without the other. The third investor fear is ”High Inflation.” In this article we discuss each fear, its current threat, and how to protect against it.
The National Bureau of Economic Research (NBER) defines a recession as “a period of falling economic activity spread across the economy, lasting more than a few months.” The NBER is the private non-profit organization that announces when recessions start and stop. It is the national source for measuring the stages of the business cycle. In other words, we have a “recession” when the NBER says we have a recession. That said, the common, unofficial, definition is a decline in GDP growth that lasts 2 quarters or more. In a nutshell, a recession is a reduction in economic activity
A market correction is defined as a 10% drop in a stock market index, and the S&P 500 is the customary index for this determination. A market correction is also known as a bear market. Plus, like a recession, a correction has to last a certain number of months. A bad month is not a recession or a correction.
High Inflation, also known as Galloping Inflation, occurs when prices increase by more than 10% in a year. Increases in the Consumer Price Index (CPI) for all goods is the common measure of price increases. By contrast, Hyperinflation is much more serious, and is defined as price increases of 50% or more in a month.
There is some debate about whether recessions cause market corrections or market corrections cause recessions. The data favors the latter – market corrections cause recessions – because bear markets have generally preceded recessions. Some say stock market behavior is a leading indicator of economic activity, but this is mostly semantics. Reductions in wealth caused by market corrections trigger less spending, which slows economic activity. Dr Robert Haugen was among the first to identify this causality. Here’s the history of the sequence of bear markets relative to the start of recessions:
According to The Balance, recessions cause:
- Increase in unemployment (16,000 jobs were lost in 2008)
- Consumer purchases decline
- Businesses go bankrupt
- People lose their homes (Home prices fell 10% in 2008)
- Young graduates cannot get a good job
A recession becomes a depression if it lasts two or more years.
As the Federal Reserve moves to stabilize the economy with fiscal and monetary stimuli, inflation can result, as it did in the 1970s when the US suffered from “StagFlation”, the word for economic stagnation combined with high inflation.
- Instability introduced by a shock, like an attack by a rogue nation, Iran or North Korea, or a dirty bomb.
- Sustainability of a slowdown, like the current squeeze on supply chains associated with trade wars, especially with China
- The Fed may have used up all of its ammunition for averting a recession. Interest rates can’t go much lower, and signs of stress have shown up in the Fed funds rate.
- The price of gold has increased over the past six months.
CNBC has documented these 6 defensive strategies.
- Don’t panic. Make sure that you have the risk capacity and investment horizon (when you need principal or income) to weather the storm.
- Take stock of your personal life. Is your job secure? Can your family live without an income for a reasonable time?
- Make a plan. How will you react to the next recession?
- Move assets to CDs and money market funds. This is a market-timing decision.
- Don’t run up your credit cards. You may find that you can’t pay them off.
- Stay rational – temporary recessions are not the end of the world.
The primary effect of a market correction is investors become poorer because their assets decline in market value. Consequently, they spend less and economic growth slows. The consumer is key to economic growth and decline.
There’s one group of people who suffer the most from a market correction – those who are in transition from working life to retirement. This group has their lifetime savings at risk in 401k plans and IRAs. For example, there are 78 million Baby Boomers in the process of retiring. Millions of them are in a risk zone, the years immediately before and after their retirement dates. Losses in this risk zone can result in reduced standards of living during retirement, deferred retirement dates, and a reduction in the length of time that savings last, even if markets subsequently recover.
The US stock market is currently enjoying the longest recovery period on record, exceeding 10 years. US stocks have returned 250% over the past decade, bringing Price/Earnings ratios above 30, as contrasted to an average P/E of 15. US stocks are very expensive. There are currently high expectations for future growth.
High prices generally precede a market correction, but sometimes prices continue to rise for a long time, as they did in the “Growth Bubble” of the late 1990s. The mantra of the 1990s was “the trend is your friend.” Today it’s FOMO – fear of missing out.
No one knows when the next correction will occur or how deep it will be. It’s like the shifting of tectonic plates. We know it’s coming. There will probably be a catalyst like a natural disaster or a flare-up from the world’s debt crisis, that is discussed in the next part of this article in Inflation.
The best defense is moving all or a significant part of your invested assets to safety, like US Treasury Bills and Treasury Inflation Protected Securities (TIPS). For many this move is market timing, which most agree is hard to do right because entails a second decision, namely when to get back in the market. This may also be impacted by the FOMO syndrome.
For some this move is “risk management” rather than market timing. People in the Risk Zone (the few years before and after their retirement dates) should be protecting their assets regardless of their market outlook. By protection we mean 70-80% in Treasury Bills and TIPS. Once they’re safely through the Risk Zone investors can plan to re-risk to extend the life of their savings.
But there’s another consideration. Treasury Bills will not be a safe investment if we suffer serious inflation rendering cash less valuable. Inflation is our next topic.
Inflation undermines the purchasing power of what is sometimes called “fiat money”, namely cash. A loaf of bread would cost 50% more following a 50% rise in inflation, but most don’t believe inflation can exceed 13% because that’s as high as it has ever been. In Inflation, When Art Thou, Professor Craig Israelsen suggests that historical inflation ranges set the bounds for future ranges, but that’s just not true. A few years ago, the Cato Institute released its working paper on “ World Hyperinflations.”
How bad can inflation become? The Cato Institute working paper examines the 56 occurrences of hyperinflation across the globe. The worst of the worst was 200% per day in Hungary from August, 1945 to July, 1946.
Many believe that we will see serious inflation around the globe because we cannot afford the humongous debt we’ve incurred. Inflation benefits the borrower at the expense of the lender. For a painfully funny borrower perspective, see the “Saturday Night Live” skit at China Sin-Drome.
Per capita world debt has soared above $200,000. The world economy is running on the fumes of delusory borrowed money, playing an outlandish game that will not end well. We owe each other money that won’t be paid in today’s dollars. That’s why crypto currencies were invented. Fiat money only works if we all agree to honor it; otherwise it’s just pieces of paper. US currencies were debased in 1971, when they were taken off of the gold standard and replaced by “In God We Trust.” Now debasing means printing money, or monetizing the debt. Lenders lose when borrowers control payment values.
The major countries are the most broke, namely the US, China and Japan. The US is even more broke that you think, including its social programs. Signs of weakening credit quality are also appearing in China, where 2018 and 2019 were record years in corporate bond defaults.
“You cannot fix a problem that you refuse to acknowledge.”
― Margaret Heffernan, Willful Blindness: Why We Ignore the Obvious at Our Peril
Sticking our collective heads in the sand and hoping the problem goes away is not a solution. But no politician who wants to stay in office will acknowledge the problem and deal with it. They want to delay the day of reckoning, but this delay cannot be indefinite. We need to protect ourselves because our leaders will not.
Treasury bonds will not provide the safety that they have historically offered because they’re at the heart of the problem: financing massive debt. A well-diversified portfolio of inflation-protected assets will help, like Treasury Inflation Protected Securities (TIPS), commodities, and real estate.
There will always be life events to which we each react in our own ways. Since we only get one life path, each decision is very important. Today’s decisions weigh heavily on our future, so it’s important to have a lifetime investment plan that puts today’s decisions into perspective. That’s why we created GlidePath Wealth Management to help investors deal with life’s investment challenges.
There’s plenty to keep us all awake at night, but that’s a good thing. We need to be prepared for the worst, and grateful for the best. Please feel free to contact us for help.