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Are We Heading Into a Recession?

By Sylvia Kwan

It’s official. After skirting tauntingly close to the edge, last week the S&P 500 closed down more than 20% from its recent high in January. That means we’re officially in a bear market. So now the question on everyone’s mind is: Are we heading into a recession?

Of course, that’s not as easy to predict as news headlines would have you think. So I’ll come at it sideways by thinking through some of the other questions we’ve heard from the Ellevest community.

First, though, let me just say: Bears can be scary — but just like you shouldn’t scream and run if you encounter one in real life, now is not the time to panic or pull your money out of the markets. As painful as they feel, bear markets are a natural part of investing, just as bull markets are. Since 1928, stocks have historically experienced a 10% average annual return, and those returns came from staying invested through thick and thin, for better or for worse — not selling in a panic. The investing journey is by no means a straight and smooth path. Along the way, we’ll encounter downturns and setbacks, as well as bull markets and periods of high growth.

While every downturn is caused and characterized by different factors, one theme seems most common in bear markets: excess. Excess risk, excess credit, excess capital chasing after returns.

How does what’s happening today compare to the Global Financial Crisis (GFC) of 2008-09? 

The GFC was brought on by an excess of borrowing and easy credit, which isn’t what’s driving the downturn today. Mortgages were extended to individuals with lower credit scores who really couldn’t afford them. When home prices peaked, many defaulted on their payments, leading to a rapid decrease in the value of mortgage-backed securities (MBS), a type of investment that pools individual mortgages together. As the value of MBS assets plummeted, banks who’d invested a lot of money into them faced a liquidity crisis (that is, they didn’t have enough cash on hand). And the dominoes fell from there, nearly bringing down our financial system. 

In the aftermath of the GFC, the government introduced new regulations intended to strengthen our financial system. They make us unlikely to experience the same issues that led to the GFC, even as access to cheap credit over the last decade has driven people and corporations to take on more risk.

So what’s driving this bear market? What might we actually compare it to?

In a nutshell, this downturn is the result of higher-than-expected inflation, the Federal Reserve increasing interest rates to combat it, and signs of a slowing economy. 

Up until now, we’ve enjoyed more than a decade of near-zero interest rates and low inflation. That drove stocks — primarily technology and high-growth stocks — to dizzying heights. When these so-called “Goldilocks” conditions start to deteriorate, the riskiest and highest-valued assets deflate the soonest and the fastest. Case in point: the NASDAQ is down more than 33%, and cryptocurrencies — one of the riskiest asset classes — are down more than 70% from their peaks. 

These losses are giving me a feeling of deja vu, but not about 2008. Remember the dotcom bust of the 2000s? (Our younger readers won’t, but trust me on this one.) During the runup to that time, there was an excess of capital (particularly venture capital) chasing internet companies — like Pets.com (sock puppet, anyone?), Webvan (a precursor to Instacart), and Kozmo.com (an early incarnation of Postmates). Capital poured into young companies that had little revenue to speak of, let alone profits, anticipating that both were sure to come with time. Share prices of internet companies rose higher and faster than their brick-and-mortar peers thanks to the excitement and potential of the new internet age — not dissimilar to the hype and YOLO / FOMO buzz generated around cryptocurrencies and related products in recent years. 

Today, as in 2000, there’s been an excess of capital chasing digital assets with auspicious yet highly uncertain and unknowable futures. (Note that a number of successful technology giants, like Amazon and eBay, came out of the dotcom rubble. I’m betting we’ll see some winners in the crypto / decentralized finance space emerge in the future, too, but who knows which ones.)

All that said, there’s at least one important difference between the internet companies of 2000 and the tech stocks of today, and that’s revenues and earnings. Compared to 2000, the weighted average revenues of tech stocks today are ten times greater. The internet companies of 2000 had little to no revenue and negative earnings, yet investors continued to drive their stock prices higher. The stock prices of today’s technology companies more closely reflect their fundamental values and earnings growth (which has increased year after year until recently). So it’s definitely not apples to apples.

When will we get to the other side?

Of all the drivers of this bear market, inflation is the most critical to watch. That’s because the Fed plans to keep raising rates until they see inflation deflate and stabilize. Plus, lower inflation will also ease consumer worries and boost confidence in the economy. 

Some believe one of the main drivers of this high inflation was an excess of fiscal and monetary stimulus measures passed in order to provide pandemic relief. Recent research shows that the stimulus support may be responsible for raising inflation about 3% at the end of 2021, primarily by raising income. But also, pent-up demand during pandemic-related lockdowns and constrained global supply chains drove supply down and demand — and inflation — up as COVID-related restrictions were lifted. Then Russia invaded Ukraine, and supplies of commodities like oil and agricultural products were squeezed, further straining supply. And China’s zero-COVID policy is causing more lockdowns in the country that have exacerbated supply chains even more. 

While the Fed is working to combat rising inflation by raising interest rates, some factors contributing to inflation are simply out of its control. We’re starting to see certain deflationary signs, like a slowing housing market and retailers with excess inventory, but we still can’t know how long all this will last.

So … are we heading into a recession?

Recessions often, but not always, accompany bear markets. (Reminder: A recession is defined as a decline in the economic output of the economy over some time, generally measured by negative GDP growth that lasts more than a few months.) While some strategists are predicting a recession, others argue that the continued rise in employment runs counter to what normally happens in recessions. It’s frustrating not to know, but only time will tell. Truly, at this point it could go either way. 

But whether we are or we aren’t headed for a recession isn’t as important as you think if you’re investing for the long term. Historically, we have always recovered from bear markets (and recessions), and then some. And this bear market will eventually end as well. What I don’t know of course — and no one does — is when. We can only be sure of that in hindsight. 

So the most prudent thing you can do now is what you should do if you encounter a bear in real life: Stay calm. Don’t panic and run. Keep investing regularly. Review your financial goals, and make sure you’re working with an advisor who’ll help you diversify properly according to your time horizon. Be patient, and don’t poke the bear.


Disclosures

© 2022 Ellevest, Inc. All Rights Reserved.

Information was obtained from third-party sources, which we believe to be reliable but not guaranteed for accuracy or completeness.

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The practice of investing a fixed dollar amount on a regular basis does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.

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Sylvia Kwan

Dr. Sylvia Kwan is the Chief Investment Officer of Ellevest. She researches and oversees Ellevest portfolios and develops the algorithms behind Ellevest’s investment recommendations.