There are two approaches to investing. The first intentionally pays no attention to where we are in the economic cycle, accepting there will be ups and downs for the economy and markets, but trusting that global economic growth drives markets higher in the long term. The second tries to time the markets, aiming to sell risky investments at the top and buy them back at the bottom.
The first involves investing in a balanced portfolio of equities, bonds and alternative investments and then just remaining invested. It is important to realise that a different balance will be appropriate for different investors, depending on their investment objectives and their ability and willingness to experience both the potential rewards and risks.
As for the second approach, timing market peaks and troughs is challenging. Many investors could be best served by the first ‘buy and hold’ approach. Even professional investors struggle to time market peaks and troughs. For psychological reasons, the average non-professional investor is unfortunately probably more likely to buy near the top and sell near the bottom.
Pick and mix
Alternatively, one could mix the two different approaches. An investor could start with a balanced portfolio – their benchmark – as in the first approach, but then take a bit more risk, owning more equities when the probability of a recession appears lowest. This typically occurs just after a recession. Following this, they could gradually return to their benchmark portfolio as the economic cycle matures, guided by the falling unemployment rate.
They could try to get back to their benchmark early, well before the market peaks. Deciding you want to be early makes the timing easier than trying to precisely time the top. Getting back to benchmark early isn’t a problem as long as the investor is happy with their benchmark portfolio, whether the market falls or rises.
This strategy could potentially improve returns relative to benchmark in the early and middle stages of the economic cycle, while aiming not to give up that outperformance towards the end of the cycle.
Predicting recession
Within this framework, to believe that now is a good time to take more risk than an investor’s benchmark portfolio, one has also to believe that a recession is unlikely in the next couple of years, or that the market has already priced it in.
With the unemployment rate falling to very low levels, the risk of a recession in the next couple of years has been rising. While the market has now priced in a higher probability of a recession than it was pricing over the summer of 2018, a recession is probably not yet fully priced in.
Key indicators
All things considered, the key question is when should one return to taking more risk than a balanced benchmark portfolio?
There are two approaches, one uses valuations and earnings, and the other economic signals. The elevated level of corporate earnings must be taken into account when considering price to earnings ratios and the extent to which equities are cheap. Also, markets historically bottom and peak at different valuation levels in each cycle.
Investors may therefore want to focus instead on the fact that equity markets tend not to bottom until consensus estimates for corporate earnings over the next 12 months have fallen and then started to rise again. When it comes to economic signals, markets tend not to bottom until after the unemployment rate has started to rise.
Another labour market indicator worth paying attention to is initial jobless claims and the number of people signing on for benefits in the US. This tends to move slightly before the unemployment rate. A good time to take more risk is often when this indicator has started to fall from high levels. Consumer confidence also tends to hit very low levels before the stock market bottoms.
A fine balance
Overall, recession risk during the next couple of years is higher than average and the signals that have often suggested the market has already fully priced in a recession are absent.
It is still wise to consider holding a balanced portfolio, with no more than benchmark allocations to risky assets you would be happy holding whether markets fall or rise.
The time to take more risk will come again, but probably in the next recession.
Mike Bell is a global market strategist at JP Morgan Asset Management
