How Investors Can Know When a Recession is Coming

The most important quality for an investor is temperament, not intellect.” – Warren Buffett

By Ed Emerson

Wouldn’t it be wonderful if we could know with some degree of certainty when the next recession was coming?

Now, I don’t mean the exact day and hour that the four horseman of Wall Street’s next apocalypse will ride into town – and you can be certain that they will do so again and again and again in the not-so-distant future – but just a semblance of when financial Armageddon might happen or at least the signs that could tell us why this time those darkening clouds are for real.

There is no shortage of so-called “Black Swan” hunters out there – a term coined by Nassim Nicholas Taleb, the former trader and risk analyst whose book Fooled By Randomness in 2001 used John Stuart Mill’s black swan logical fallacy as a new term to identify falsification.

And they come in various shapes and sizes; media commentators, market pundits, economists, financial advisers and even self-anointed market swamis employing a range of algorithms, market indicators, sentiment readings and even seances with the ghost of Joe Granville – the surprisingly popular face of investor negativity despite his remarkably bad investment track record.

The problem with most if not all of these folks is consistent inconsistency: Every year, quarter, month or even week they’re predicting the investment market recession that never arrives. Some would call it the “chocolate watch” approach, meaning that even a chocolate watch gets the time right twice each day.

Have you ever really thought about your path to financial security? You can do that here.

It’s the repetition, and repeatedly wrong predictions, that drive investors to distraction…and lost revenue. Obeying the whims of market volatility and then running for cover when some dour guru claims the black swans are circling leads to the horrific cycle of:

  • leaving the market at a price lower than you paid to get in (and don’t forget charges/commissions/taxes)
  • putting your money into something that gives you shit returns in exchange for the feeling of “safety”, and then
  • coming back into the market later and paying even more than you did the last time round.

This buy high, sell low process is all too common and creates massive distrust amongst investors – thus the reason market sentiment is so unbelievably low right now despite the ballistic ascension of indexes like the Dow Jones over the last seven and a bit years. Investors miss the gains when they leave in expectation of every false apocalypse, then grow bitter because they reacted to that fear and blame the market for their own behaviours.

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It doesn’t have to be that way. There are a few things you can do, and a few things to watch out for. These are not hard and fast rules, they are signposts to keep you sane when everyone seems certain the next black hole is vacuuming up all the remaining light:

1) The Market Consensus is Wrong

When everyone seems like they are in agreement on the direction of the market you can be certain that they’re wrong. By example, if you are reading this post today and you notice the vast majority of financial articles and opinions are suggesting we’re headed for a crash, or that nirvana is now upon us and we’re in a new era of never-ending market prosperity, look the other way.

The herd has never been right. It’s almost as if the market has a devious personality that waits for sentiment to pile up on one side of the see-saw and then drops a really fat guy on the other end to make everyone fly off.

What a wonderful sense of humour, eh? In practical terms, the AAII American Association of Individual Investors provides a regular index that tells us how folks are feeling about the stock market right now. The readings continue to tell us that sentiment is as low now as it was back in March 2009 when we first emerged from the last recession.

Look at that as a positive sign. It’s only when everyone is euphoric about the market that you might want to either put your parachute on or take a deep breath. Remember: Recessions only last about a year on average. Bull markets on average last about five times that long.

2) The Destiny in our Demographics

Mike Williams of Genesis Asset Management in Chicago and Alan Steel of Alan Steel of Alan Steel Asset Management in Scotland are two of my favourite market commentators. One of the reasons for this is that they focus on demographics, not as the end-all-be-all of investment strategy, but as part of a crucial set of indicators because they see the impact of generations like the Baby-Boomers and now Generation Y on the growth of economies and markets.

What we are seeing now is the arrival of Gen Y as the largest demographic cohort ever. The innovations, buying power, economic impacts on the requirements for new homes, vehicles, products and services will be greater to feed this generation than we’ve ever seen before.

3) The Flow of “Nonsense Money”

Other than the folks noted in Martin Lewis’s book The Big Short, and Joe Kalish at Ned Davis Research, I’m not aware of any credible claims of anyone else having foresaw the last recession. They’re exceedingly difficult to spot. If you think about it, of the nearly 7 billion people on the planet only a handful thought something smelled funny.

Of course in hindsight it all seems abundantly clear: Wall Street colluded with the ratings agencies to circumvent the regulations surrounding the mortgage market with a variety of dubious financial products, probably made trillions from those activities and then got fined billions after the fact. Not a bad deal for Wall Street from an accounting perspective.

But it was the flow of “nonsense money” that should have tipped us all off and didn’t. We were all so caught up in the fact that anyone with a pen and an income self-certification “liars loan” application could buy a house and get extended ridiculous amounts of credit. It made no sense. And when the introductory mortgage rates ended and the credit card bills and interest on top became insurmountable, the debt mountain was inevitably going to fall down.

So where do we see the flow of “nonsense money” now?

The media points to Greece. And while the repeated EU / IMF funding of that country is as frustrating as it is ridiculous, the bottom line is that Greek GDP in global economic terms is about half that of the state of Florida. Not exactly a recessionary black hole. And I’m put off that everyone thinks it could be, because the consensus is always wrong.

The same goes for China. Investors should not be surprised that a communist regime would lie about growth figures to prop up its own economic interests and kidnap any journalist who dared reveal that scenario to the world at large.

Nope, what we’re looking for are high potential suprises, the secret or not-so-secret movements of money to fund things that could not possibly return what they borrow or owe, or those things that encapsulate frauds of such magnitude that the nefarious activities of $mutli-billion rogue traders pale by comparison.

Ones to watch include:

  • An unexpected climate event or series of same that overwhelms our ability to compensate for it.
  • The disruption of IPCC and other climate change related expenditure, should global warming reverse course in spite of our failures to curb emissions/pollution etc., and then bankrupts all those renewable energy programmes and research initiatives throughout the world.
  • The discovery of a fraud, like all the gold in Fort Knox propping up America’s wealth is actually no longer there, and some clever soul from the Discovery Channel finds a way to prove it.
  • Wall Street reinvents Collateralised Debt Obligations (CDO) and credit default swaps by another name – those that served as the linchpin for the last recession. This one could already be in the works…
  • A domino effect of the collapse of a group of sovereign wealth funds because of their similar investment strategies. 

Right now nothing like the above scenarios seems patently obvious, but we can at least draw the distinction between the more popular but less likely signs of bad things to come, and what investors should know about how to spot a recession.

First, why not have a read of Why Watching Stock Market Indexes is a Waste of your Time which offers a different view on all the constant media focus about the performance of indexes and how little that actually has to do with your investments. 

Now, have a look at the resource article for investors in HNW Magazine’s Investors & Investing – Winning Long section here.

Then do this – Make sure you don’t miss these signposts. Sign up to get HNW Magazine sent to you every week. It’s free, it’s easy and you can do it right here.

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