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The last few months have been spent in book promotion mode and as a result, we’ve been blissfully unaware of what’s been going on in the news, especially in the stock market.
But just because I wasn’t paying attention doesn’t mean nothing was happening, because apparently…
Global markets took a left hook to the chin on Wednesday, with the TSX Index shedding nearly 2% over the inverted yield curve.
~Danger, How to Invest After Wednesday’s Yield Curve Inversion, Yahoo Finance
Stocks and oil prices plummeted Wednesday, with the Dow Jones Industrial tumbling 800 points — the fourth largest daily point drop on record and the worst this year.
~Dow plummets 800 points on worsening global recession fears, Fox Business
Sigh. Here we go again.
So once again, in case people have been lulled into a false sense of security about the stock market always heading up-and-to-the-right, this week has been a rude awakening. The stock market is VOLATILE. These kinds of events happen all the time. If you’re going to be an investor in the stock market, you’re going to have to be OK with the occasional 800 or 1000 point drop. If you can’t handle the heat, get out of the kitchen.
And as usual, a big scary drop like this has sent all the talking heads on the news into overdrive trying to predict what it means, and whether the second longest bull market on record is finally coming to an end, and they’re all trying to answer the same question.
Is there a recession coming?
And the answer to that is…YES!
But that’s not nearly as useful or as bold a prediction as it seems. There’s ALWAYS a recession coming up. The stock market (and the global economy in general) is not designed to be steadily increasing in a slow but steady way. It expands, then overheats, then contracts, then recovers, and then expands again. It’s a cycle.
Everyone knows (or should know) that a recession is always around the corner. But the big hairy trillion dollar question that nobody, not me, not the talking heads, heck not even the chairman of the Federal Reserve, knows is precisely WHEN the next recession will hit.
So let’s break down all the stuff that’s been happening in the news and see what it could possibly mean for stock investors.
The Case For an Impending Recession
Reason #1: This Bull Market Has Been Super Long
We’ve all been enjoying a pretty substantial bull run in the stock markets, basically since the end of 2009. This is now the second-longest bull market in history, and it’s made a lot of people a lot of money. The party’s got to end at some point because the economy can’t continue expanding at this pace forever.
Reason #2: The Yield Curve Inversion
The last time the Yield Curve inverted, I called it a bit of a fake inversion. That’s because while the media kept calling it a yield curve inversion, only a small part of the curve actually inverted. This time, however, it’s a much more substantial portion of the yield curve, namely the 10Y versus the 2Y.
And as the media is breathlessly pointing out, yield curve inversions are a pretty solid predictor of recessions. Every recession in the past was preceded by the yield curve inverting, and we’re in that situation now. Therefore, a recession must be right around the corner, right?
Reason #3: The US-China Trade War
And oh yeah, Trump’s in the White House and he’s still fighting with everybody. Specifically, the Chinese.
The US-China trade war is the single largest threat to the global economy, and unfortunately nobody knows how it’s going to end. As I’ve written before, this is actually something I agree with Trump’s positioning on. He’s basically going in there and asking, “Hey, can you please stop stealing our IP?” And China, being China, has responded with trickery, deceit, and a trade war. Again, never trust Communists.
The Case Against an Impending Recession
Reason #1: Bull Markets Don’t Die From Old Age
The argument for a recession based solely on “it’s been awhile, so we’re overdue for one” is overly simplistic. Bull markets don’t end just because they’ve been going on for a while. They end because one of two things happen: The Federal Reserve raises interest rates too high which chokes off the economy, or an external geopolitical shock. And right now, the Federal Reserve is actually doing the OPPOSITE of raising interest rates, so that’s not going to do it. An external geopolitical shock may happen, but as usual nobody can predict when precisely that’s going to happen.
Reason #2: The Yield Curve Is Far Less Useful Than You Think
I’m also not buying the line that just because the Yield Curve inverts, then BOOM a recession has to happen. The Yield Curve is just a signal of trading sentiment in the bond market. Nothing more, nothing less. And when the Yield Curve steepens, flattens, and in this case, inverts, you have to interpret WHY bond traders are trading that way. Are they worried about deflation? Are they worried about the US government defaulting on their debt? Are they worried about unemployment?
In this case, none of those fears are actually manifesting themselves. So why has the yield curve inverted?
Simple. They’re predicting a drop in interest rates.
In June, the Federal Reserve surprised everyone by announcing they’re going to drop interest rates. They’re actually not supposed to do that in a booming economy, but Trump is pressuring them into it for political reasons. That in of itself is a worrying sign because the Fed is supposed to be politically neutral, but when interest rates drop, bond prices shoot up. Specificaly, longer-duration bonds shoot up faster than shorter-duration bonds, so this would have the effect of bond traders dumping short term bonds and buying up longer term bonds. This would cause the prices of short bonds to go down, and long bonds to go up. And because yields move in the opposite direction of bond prices, this would cause short yields (like the 2Y) to go up, while longer yields (like the 10Y) to go down. That’s exactly what we’re seeing. Bond traders are betting on future interest rate cuts, so they’re positioning themselves accordingly.
Does this predict a recession? Not really. Remember, recessions are caused by interest rates increasing too fast, not dropping. So yes, the Yield Curve inverted but I’m not seeing this as a predictor for an impending recession. Quite the opposite actually. I think this will boost the stock market in the short term, and possibly lead to it overheating.
Reason #3: The US-China Trade War Could Still End
Maybe this is the eternal optimist in me, but the US-China Trade War could still end on favourable terms for everyone.
The problem right now is that Trump hasn’t exactly made it easy for China to do it. In Chinese culture, there’s a phrase “saving face,” which essentially translates as “don’t want to look like an idiot”. And however China is going to end this trade war is going to need to allow the Chinese government to “save face” while doing it.
Unfortunately, Trump being Trump has employed his usual “my way or the highway” method of negotiation, and no government wants to been seen as weak and capitulatory, least of all the Chinese. So Trump and his negotiators need to come up with a way for China to say “Yes” to their terms while also not losing face by doing so. It’s not exactly in his skill-set, but I’m hopeful SOMEONE in his administration can come up with something.
What Do I Think Is Going To Happen?
Here’s where I’m going to do the exact thing I’m not supposed to do and try to predict the future. Before we go into that, I’m going to caveat it by saying that this is, like every other talking head out there, a guess. I’m guessing, and in no way shape or form should you make any financial decisions based on what I’m about to say. Stay invested, stay the course, and ignore all predictions. Like the one I’m about to give π
I think the next recession, whenever that comes (which again, nobody knows) is not going to come from the Yield Curve inverting, or Federal Reserve policy, or even Trump doing/saying something stupid. I think the next recession is going to be caused by Beijing.
Like I’ve said, the single largest threat to the global economy is the US-China trade war because of how large and integrated the Chinese economy is in the world’s supply chain. It’s the largest trading relationship the US has, and if that gets blown up everyone loses.
And this trade war was started by Trump not even asking for anything that unreasonable. Just stop stealing our IP and we’ll drop all tarriffs. Any rational negotiator would have sheepishly said “OK, fine.” But the Chinese Communist Party is not a rational actor.
If you’ve read our book, you will know that FIRECracker has a…let’s say complicated relationship with the CCP. They caused a famine, tried to murder her family, they sent her Dad off to a labour camp for 10 years. So let’s go ahead and call that relationship…less than cordial.
And during all that hardship, something the Communists have shown is that they’re really, really bad at admitting when they’re wrong. They deliberately sent the country into a famine in the 60’s when Chairman Mao implemented his first attempt at communism during the Great Leap Forward, and then they tried it AGAIN during the Cultural Revolution in the 80’s. Communists don’t admit when they’re wrong, they double down. And they don’t care if it destroys their economy and kills millions of people. They would rather do that than lose face and be seen as weak.
Which is why how China behaves in the trade war is so important to the world economy. Will they admit that stealing everyone’s IP in the past was a mistake, or will they shoot themselves in the foot rather than compromise?
And that’s why the indicator I’m watching the most closely is not the Dow, or the Yield Curve. Rather, it’s Hong Kong.
Why Hong Kong Is Important To the World
With all the shootings in the US news lately, you can be excused for not paying attention to what’s happening in Asia, but to catch you up, right now Hong Kong is roiled in protests that have basically paralyzed the city for 8 weeks. What started it was incredibly stupid. Basically, the Hong Kong government introduced a bill that would have allowed Hong Kong citizens to be extradited back to mainland China for prosecution. This is very very scary to the people of Hong Kong, because the Chinese justice system has been used to persecute political enemies, so theoretically this bill would have allowed Beijing to arbitrarily arrest anyone in Hong Kong and disappear them.
All the protestors wanted was for the Hong Kong government to withdraw the bill. That’s it. But they refused, instead suspending it from debate, which just delays it from being considered.
Since then, the protests have gotten bigger and bigger, and have morphed into a pro-democracy movement.
Beijing has thus far stayed out of the situation, but they’ve ominously said that if the situation doesn’t come under control soon, they’d be willing to “intervene” militarily.
Here’s the thing: Hong Kong is the financial jewel of China. Not only is it a strategic and historically important trading port, it was the gateway from China to the West. Their transparent judicial system and strong financial regulations allowed investment dollars to flow from rich Western economies into China, and is a major reason that China is now a global economic superpower. In short, Beijing needs Hong Kong. Just like Beijing needs the US.
So how they handle this situation in Hong Kong will be a pretty solid predictor of how they will handle the trade war. Will they make concessions, admit that they’ve made past mistakes, and compromise in order to restore peace to their golden goose? Or will they send in the tanks, kill thousands of people, and crash their own economy in order to not admit when they’re wrong?
I admit I have a personal stake in what’s happening in Hong Kong. While FIRECracker’s family came from Sichuan, mine came from Hong Kong. Watching the city descend into chaos breaks my heart, and I have a vested interest in seeing the protests come to a peaceful ending.
But what’s happening in Hong Kong doesn’t just affect the people there. It affects everyone, because it’s a microcosm of how Beijing is going to behave on the global stage. If they refuse to compromise in Hong Kong, violently crush the protestors, and destroy their own economic crown jewel just to not admit when they’re wrong, they’ll likely do the same in negotiating with the US. What happens in Hong Kong will affect the world.
So going back to the original question, is a recession coming? Eventually. But if you want to know when, I don’t think the answer will be in the Yield Curve. The indicator I’ll be watching is Hong Kong.
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Thank you for spelling it out. I’ve been following, a bit, over the last month or two; it’s easy to see organized, peaceful, dedicated protesters by the hundreds of thousands and simply think to myself “yeah, they’ve got a point, wtf is up with the government.” But I didn’t follow how it could tie into the wacky financial issues of the day, nor did I realize the depth of HK’s history as it relates to China’s economic rise. Taken together it’s breathtaking.
Oh yeah. The history of HK’s relationship with China is super messy and complicated, rivalled only by Taiwan’s.
I hope your family is okay in Hong Kong. I doubt Beijing will compromise. From what I read/heard, they don’t need HK that much anymore. Hopefully, they will come to some kind of peaceful resolution.
As for the trade war, they could hold out at least another year to see if Trump is reelected. It’s just one year. They can figure out what to do after 2020.
I agree that it’s easy for China to hold out another year to see if Trump is reelected or not. Actually, they can hold out 5 more years. One thing China has over the U.S. is they think long term, so they’re much better at waiting things out. It’s their biggest weapon, in my opinion.
Oh, and I appreciate your attempt to be objective in regard to Trump. Yeah, you don’t have to like him, but just because you dislike someone intensely doesn’t mean they are wrong about everything.
That’s actually a good point, that China can think long term while the US switches tack every 4 years.
And yes, Trump is not the most likeable figure, to say the least, but a broken clock can be right 2 times a day.
Great article. Makes complete sense yet I’ve been reading lots of news and all I have seen anywhere is “market falls because of trade war fears” and nothing more detailed. I didn’t make the (in hindsight, bleeding obvious) connections to Hong Kong, Chinese financial power and how this could affect the indexes but now I have another perspective. Thank you.
I’ve been reading the same news. A lot of reporting, and not a lot of insight. I’m glad you enjoyed my take.
I like your concept of Hong Kong as a bellwether for Chinese trade policy. It’s an interesting idea, and certainly China is the biggest potential disruptor to the current bull market. But there are definitely others, including Britain/Europe’s crazy Brexit problem, which could have serious global implications if the two sides can’t figure out a solution.
I know you guys are index fund buy-and-holders, but is there any combination of inverted yield curves, Hong Kong hijinks, Brexit debacles and potential Presidential malfeasance that would make you hold a higher than normal amount of cash as a hedge against an imminent major bear market?
I was convinced. CONVINCED. That the markets would crash when Trump got elected. I said as much when we started the Investment Workshop, but I knew the right tactic was to invest anyway. The markets then proceeded to go straight up.
Nobody knows when a market downturn will happen. So don’t try to time the market.
Brilliant post. I work in finance and read a lot of βinsightsβ but nothing as spot on as this so far…
Everybody in the financial media is afraid of taking a position. I’m not, because I don’t care what anyone thinks. Truth bomb!
I agree completely that Hong Kong will indicate the Chinese government’s willingness to compromise. Likely not at all.
The rest of your analysis is spot on too. Markets are like people, if the leaders panic the sheep will panic. It’s up to us not to follow the herd but to hunker down and hang on. Gut it out, so to speak.
Question: What do you think of collectibles as a wealth preservation and growth method? I’ve had good fortune with MS 70 gold coins and with original art (oils mostly).
I have no idea what MS 70 gold coins are, and I think all paintings are stupid, so…not a fan.
MS 70 gold coins are the highest rated collectible gold coins. They are the safest and fastest appreciating form of gold investing.
If/when a recession does come, we just stay the course with our investment strategy, correct? As in keep buying/balancing our portfolio 60/40 (if that’s the mix we chose, which I did) no matter what the market does? That’s what you did in 2008, correct?
Yup. If you’re still working and your job stays intact, a recession is blessing to an index investor. Buy as much as you can when everyone else is fleeing.
the next recession may crush equities, just as we saw in 2008. recency bias can affect us all
we have been accustomed to 6-8% returns for a balanced portfolio ……could be 3-4% for the next 5 yrs. No one knows. No one saw 2018 coming; a balanced portfolio lost 5% , was it?
part time job anybody?
How did such balanced portfolio return after the dot com bubble during 2000-2009 when equities returned negative for the decade?
Agree that China will not back down, but the cultural Revolution was over well before the 80s, and the violent crack down in 1989 only strengthened the Communists power…
it took TWO years for a balanced portfolio to get back even after the 2008 debacle
dont let recency bias infect you, and careful ‘assumming’ what average will be. NO ONE can predict the future
have a plan C….just in case π
A balanced portfolio lost 20% peak-to-trough. But because we kept buying, we made it back to break even a year later.
which is awesome!!….and lets all hope history repeats itself. That at the next recession, as we keep buying as the market drops….if comes back just as fast?
Powell to speak tomorrow. QE3 is the only recourse. He saved the day in early Jan 2019, need him to deliver tomorrow…….but of course it will all be okay..:)
Bryce this is an awesome article and I LOVE the clarity of your thinking and how clearly you laid it out. Thank you for writing this and I enjoy reading every time. Alan
Always a pleasure, buddy!
Thank you for the thoughtful comments on Hong Kong, it was a good read. I also enjoyed the βnever trust communistsβ linked back, had not seen it before.
A recession will come eventually. May your companies be strong…and preferably with low multiples and good dividends to weather the storm.
Glad you enjoyed it. And also, never trust communists π
Hi Wanderer,
We often give the advice to just stop watching the news and focus on the things you can change.
While this is true for most things, there is also the power of individuals when expressed as a massive group.
This was expressed in the Philippines in 1985 which led to the removal of the dictatorial government. It was called the People Power Revolution.
https://en.wikipedia.org/wiki/People_Power_Revolution
This is the same sentiment being expressed by the people of Hong Kong except their goliath is exponentially larger and more powerful.
I hope that the demonstrators become successful and Hong Kong remains the vibrant and free city that I’ve visited in my youth.
Me too, friend. Me too.
You nailed it!
However, If China is waiting to see if Trump gets the boot or not before it βbends the kneeβ and admits any fault. They might want to look at the front runners against Trump and their own policies? Trump is actually mild compared to some Democratic Reps who want to stop China from become the Dominant player in the world?
Very insightful article.
I can’t imagine anyone making Trump seem “mild” in anything.
There’s no stopping China. China will be tha biggest economy no matter what…We might even win the space race! Go China! It’s our time to shine and whoever left China will regret
Thoroughly enjoyed this read. Thank you
My theory on what causes recessions is best told as a little short story. Our story involves Sally and Sam. They are in their late 30’s to early 40’s with two children, ages 10 and 12. With the economy humming along, they decide it’s finally time to update their older house and buy a new car. They aren’t alone in this thinking and soon the economy jumps into the next gear and is roaring. This gives Sally and Sam even greater confidence, and now they buy an even bigger house, Sam gets a new motorcycle and Sally plans for two fancy family vacations per year. Amazon deliveries come multiple times per week and groceries are delivered to their house (who has time to shop?). But soon Sally and Sam realize all this new stuff in their life costs money, a lot of money. They are stretched to the limit and have no savings. And many of their neighbors are in the same boat. They can barely scrape up enough money to replace the old computer or fix the A/C if it goes out. And then a little bit of bad news about the economy makes its way to their ears. They get nervous and realize they better start saving a little bit in case of a layoff. The restaurant trips are cut back, the grocery deliveries stop, the Amazon addiction is cut in half. Sam sells the motorcycle for 50% of what he paid for it and the vacations are now more local. And they aren’t alone in this behavior. And then the recession begins.
@Superdave, Finally somebody with some sense!!!
All of these so called financial experts are so engrossed in the financial markets that they are missing the main reason an economy goes into recession.
These so called experts are so engrossed, they forget that all financial markets are constantly being manipulated to suit somebody’s preferred outcome. This unfortunately is what is learned during any financial or economics course studied.
The real indicator of the true situation of an economy is household spending, hence why most countries have interest rates so low. Governments and Central Banks are doing everything possible at the moment to try to encourage households to part with their hard-earned cash because they realise that most economies are in a perilous situation.
So it’s time for all of these experts to stop trying to push figures from manipulated markets down people’s throats, step out into the real world and see what is really going on.
No money being spent = businesses going bust = people losing jobs = no money to spend = RECESSION.
That is the real world!
These so called financial experts are millionaires and retired.
If you want to spend you way to oblivion, be my guest. I will happily continue collecting my dividends from your money.
It seems there’s always fear of a recession and I wonder if one talking-head spraying it over the television cameras causes the investing community to pause and secondary news outlets to relay the idea. This would have the effect of causing a recession just because someone mentioned “recession.”
It’s like brake lights. Traffic is moving along fine but one person can’t handle the thought of what lies over the hill in front of them so they hit their brakes. Other people see brake lights and envision crawling traffic on the other side of the hill… so they hit their brakes too. This causes a chain reaction that leads to slow traffic or what’s known as “Brakelight Hills” where the slow down is caused by literally NOTHING and traffic smooths out on the other side of the hill.
But what if there WAS a wall of cars on the other side and some people misjudged their use of the brake pedal…
Oh yeah, economies can totally get derailed by collective mass psychology. Bubbles form the exact same way.
But at the end of the day, people don’t stop spending because they think a recession is coming. They stop spending when they loose their job. And that’s an outcome that I’m just not seeing right now.
Unless of course Beijing screws things up.
I’m not sure why you think we are in a bull market since 2008, but whatever.
I can tell you that the world lives in cycles of 9 years and during each cycle we have two years of expansion, two years of recession and two years of instability with one transaction year in-between each case.
We are now entering a period of two years in crisis 2020-21.
I am not going too deep into this because it’s hard to explain, but the famous year of 1929 will happen again this century but in 2037…. fix that date. If you want to invest, that will be the year to go all-in. Because it’s when the blood is on the streets that we should invest the most.
“Two years of expansion, two years of recession and two years of instability with one transaction year in between” is 7 years, not 9.
Nobody trust this guy’s math skills.
Your math is as bad as your English comprehension, it seems.
“Two years of expansion (2), two years of recession (2) and two years of instability (2) with one transaction year (1×3) in betweenβ is 7 years, not 9.”
So for your 2+2+2+3 is 7!!! Bravo!!!
Anyone can see that you are basically a jerk. That is obvious.
But FIRECracker might start to think that you are not just a jerk but also bad in math….. be prepared to go back to work soon, when you get dumped.
My math skills made me a millionaire. Are you?
Actually it is 8 : 2+1+2+1+2 !
Who can you trust these days ? ?
The guy who has money. That’s who.
While I also don’t pay much attention to the daily news as we focus on traveling the world, thinking about what will cause the next recession is the least of my concern as I have little control over it.
Besides the recessions itself what prompted me to comment is the fact that you are personally involved into the terrible events happening in Hong Kong and at the end of the day what matters the most are our friends & family & especially making sure they live a happy, joyful and safe life. So I hope that your family is (and will be fine) Bryce. What is currently happening in Hong Kong is far from being either fun or safe.
Thanks buddy. Our friends and family are fine for now, but we’re monitoring the situation very closely.
I really enjoyed this post. I like reading a Hong Konger’s perspective.
I wanted to ask something unrelated.
On page 133 of your book, you write that 40,000β(1,000,000Γ0.025)Γ5 =75000 when it actually equals -85000. This is when you’re describing the yield shield. I really want to use this strategy so can you help me understand what’s going on what that equation?
Thank you.
It should be: (40,000 – (1,000,000 x 0.025)) x 5 = 75,000
The formula on the previous page is correct: Cash Cushion = (Annual Spending – Annual Yield) x Number of Years
Itβs just missing a set of parentheses. (40,000 – (1,000,000 x .025)) x 5
You must be the most anti China a Chinese ever got. It seems like you aren’t one but you are. Don’t forget that. We’re reading every bit.
We aren’t anti-Chinese. We’re anti-Communist. BIG difference.
By the law of averages, most of you will achieve financial freedom in 10 to 35 years.
Once you have chosen the time frame to execute FI that fits your particular financial situation.
The next step is to get educated on the game of finance – millennial-revolution.com is a good institution!
Once you have decided on the financial vehicles to take your hard earn money forward,
have the full confidence in them. If you don’t believe in yourself β WHO WILL?
Accumulation phrase begins once you have put your first dollar into your investment of choice.
That dollar should not have any movement until the de-accumulation phrase – when you
have crossed the FI mile marker.
The movement of that dollar will have two consequences (99 PERCENTS of the time).
First, lost gain opportunity in the choice of investment if the recession forecast is wrong.
The market is more random than the best of any mathematical model.
Second, when your dollar move, it allows opportunistic and sophisticated piranha to chip a tiny bit of value.
Most of the time you don’t even know. Otherwise, you will play a different financial game whereby, you are chipping someone else dollar.
If you believe millennial-revolution is correct with the recession forecast, do not make automatic investment with new money, but hoard up cash.
Put all that chips on the table when it rains and don’t touch the chips again until you needed to take care your family requirements.
Stay calm, play golf, go fishing and spend time with your family is the best prescription for the time like now!
Good luck!
I am going to retire next year, please advise what should I do.
Thank you.
Balanced portfolios beaten down today
Sorry
Year over year about 3%?
Volatility’s part of the process. If you can’t take the heat, get out of the kitchen.
To test the June lows at minimum folks . Then if it can’t hold , all 2019 gains to vanish as we test the Dec 2018
Keep in mind the us is running a trillion dollar deficit with ue at 3.7 % and
1/4 of the planets are negatively yielding
Keep head in sand and let’s hope all will be okay
Very well said that bull markets don’t die because of the age. So many experts keep pointing out that we are in this longest bull market and because of that recession is near. You can predict future by looking at the rear view mirror.
China doesn’t need HK. It can be easily sacrificed as a political point and any financial benefits would accrue to Shanghai and Shenzhen instead. Hk needs China, not the other way round unfortunately.
Hi, What are you thoughts on these predictions?
https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos
It feels reasonable on what he is saying – if all of us pouring money into indexed funds we essentially inflating prices of stocks. On the other hand if all market is indexed we are inflating it regardless where our money go Β―\_(γ)_/Β―
Curious on your ideas and research.
Thanks.
Love your book!
This would certainly be an interesting piece to revisit this summer, two years on.