Does it make sense to change your investments if you see a recession coming? Possibly so, but you’ll need some economics know-how.
The bottom line is fairly simple. If you can get your prediction of the beginning or end of an economic cycle correct, then it could boost your portfolio returns substantially, according to some recently published research.
An investor who could predict the start or end of a recession and then invest accordingly would add 2 percentage points to annual returns, according to a research paper from James A. Conover, David A. Dubofsky, and Marilyn K. Wiley, all professors at the University of North Texas.
[See: 7 Stocks to Buy When a Recession Hits.]
In the current world where 8 percent annual returns might look optimistic, adding 2 percent a year is a big deal.
Better still, there were gains to be made even for investors who changed their investments one month after the economic cycle turned from expansion to contraction (or vice versa), the report says.
The study was based on stock and bond returns as well as data on U.S. economic cycles over the period 1970 through 2015. The authors created a passive benchmark return weighted with stocks and short-term government bonds in proportion to how often the economy was growing or in recession, respectively. They then compared that benchmark to what the performance would have been if investors switched their portfolio entirely into government securities in a recession and entirely into stocks in an expansion.
The results showed far superior performance on average for the portfolio that switched assets when the economic cycle turned.
It’s not easy to forecast a recession. Predicting such things makes betting on horses for profit look easy.
“It is extraordinarily hard,” says Steven Blitz, chief U.S. economist at TS Lombard. The last recession was well under way before many professional economists were acknowledging the problems that economy faced. Those who saw problems as early as 2007 were often lambasted by others. It was only after the fact that such seers were proved correct.
[Read: An Investor’s Guide to Choosing Stocks and Bonds.]
Conover tells U.S. News that forecasting such things is tricky especially given that the actual dates for recessions aren’t decided until years after the fact.
In addition, recessions aren’t that common. In the last 30 years, there have been three: 1990 to 1991, 2001, and 2007 to 2009, according to the National Bureau of Economic Research, which determines the official dates.
Recessions are rare events for the U.S. economy. Growth is the normal situation so there aren’t masses of past examples to study from recent history.
What should you look at? If you’re trying to predict a recession, start by looking at the level of hiring in the government’s Job Opening Labor Turnover Statistics report.
Blitz says plummeting hiring levels (found in the the report) and rising in unemployment claims are the “best concurrent sign of an economic downturn.”
Another sign of weakness is three straight month-to-month declines in industrial production, he says. Although industrial production isn’t a huge part of the economy it is “still a good signal,” of an approaching recession, he says.
Industrial production isn’t the only way to look at the health of the factory business.
The Institute for Supply Management’s manufacturing index shows the strength of the factory economy. A reading of more than 50 shows expansion in the sector, less than 50 shows contraction, says Scott Clemons, chief investment strategist at BBH in New York.
How to invest. The study mentioned above used an assumption of switching from 100 percent stocks to 100 percent cash-like bonds. The problem is that most investors hold a balanced portfolio of stocks and bonds, which is sensible because balanced portfolios are less risky. In short, a portfolio like that used in the study doesn’t make sense.
Still, if you are confident try this suggestion, you can convert a portion of your stock portfolio into bonds when you think a recession is coming. For instance, if you have a $100,000 portfolio of 70 percent stocks and 30 percent bonds, you can sell 10 percent of your stocks ($7,000) and use the proceeds to purchase $7,000 of bonds. That would change your portfolio to approximately 63 percent stocks and 37 percent bonds.
Likewise, in a recession that you think will soon be over, switch back to a higher level of stocks.
[See: 7 of the Worst Stocks to Buy for 2017.]
However, such a move is not to be taken lightly. And any fees that you incur in making your trades reduces your potential windfall, so invest carefully.
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Forecasting Recessions Can Boost Your Investment Returns originally appeared on usnews.com