The Next Downturn is Coming: Prepare Yourself

With the U.S. stock market up over 20% last year investors have to wonder about the long term visibility of the markets. The Shiller P/E ratio is currently around 34 times.  This is twice as high as the average historical ratio of 16.82 times. The U.S. isn’t the only place where investors are shrugging off high valuations and pushing the stock up higher. Stock indexes in other markets around the world are trading above their long-term averages as well but not as overpriced as the U.S. “The MSCI EAFE index, which tracks Europe, Australasia and Far East, is trading at a forward P/E of 15.1 while the forward P/E for MSCI’s emerging-market index is at 12.8. The 10-year average for the former is 13.9 while it is 12.1 for the latter.”

One asset management company is even comparing the stock market bubble to the bitcoin bubble because of how “totally disconnected from fundamentals” both are. “Stocks are in complete bitcoin territory,” said Francesco Filia, chief executive at asset management firm Fasanara Capital, in an interview with CNBC on Wednesday. “Valuations on stocks sometimes feel like bitcoin because in a way it is totally disconnected from fundamentals,” Filia explained. “It’s purely based on sentiment and flows from central banks and the private passive investment community.”

What may finally bring the end the bull market is a contraction in the economic output of the economy. The next recession may be coming sooner than most people think, and with it a major correction in the stock markets. Often the yields on government bonds can show us some hints about when the next downturn might come. Over the past 30 years, whenever the interest rate on the U.S. government 2-year treasury bond becomes higher than that on the 10-year treasury bond a recession occurred soon after. The graph below shows the difference between the two government bonds. (10 year yield minus 2 year yield)

Ever since 2010 the difference between the 10 year and 2 year treasury yields has been gradually shrinking, albeit not in a perfectly straight line. If this overall trend continues then at some point between 18 and 24 months in the future, it is very likely the line will fall below the zero mark again. The last three times it had done this and reversed course the U.S. fell into recession, which is indicated by the overlapping vertical gray bands.

The question is how can we prepare for the next downturn in the economy. Personally I’m going to eschew the purchasing of any new U.S. stocks and buy alternative investments which is less correlated with the overall financial markets. Buying more fixed income assets should protect me against volatile times ahead. Particularly I would look at medium to long term, investment grade corporate bonds in AA to BBB range. These bonds tend to give a decent yield while not subjecting investors to the high risk associated with junk bonds. The reason I don’t want to sell my stocks and move everything into bonds is because I want to hedge my positions. One of the fundamental risk management rules is to maintain a diversified portfolio. I’m not 100% sure the next recession will hit in 2019. It could be earlier or it could happen in 2020 or later. I can’t control the timing, but I can prepare for it’s eventuality.

Another thing I plan to do is pay down my debts. When asset prices are at record highs it’s worth looking at other places for returns. The highest cost of debt I currently have is a bank line of credit with an annual interest rate of 5.5%. Paying down my debt gives me a risk free 5.5% after tax return on my money, which is not a bad outcome.

Photo Source