We’ve outperformed over the long term by being conservatively contrarian during booms and aggressively contrarian during busts.
Investors must never forget: the economic cycle includes contraction as well as expansion. Downturns usually don’t last nearly as long as upswings, and since the Second World War they’ve become even less frequent. Perhaps that’s why, as it seems to me, most investors underestimate the risk and effect of recession.
That’s a big mistake: although they’re uncommon and their duration is comparatively short, recessions nonetheless tend to cost most owners of stocks very dearly.
In the U.S. since 1937, from the pre-recession peak to the recession’s trough the S&P 500 has plunged an average of 32% and the median loss is 27%; in Australia, the corresponding losses are 24% and 21%. In this article I demonstrate that, on average in CPI-adjusted terms, recessions in both countries over the past 50 years have eliminated most of the preceding five years’ cumulative gains.
Moreover, slumps typically cast long shadows: not until 1954 did the S&P 500 rescale the height it first attained in 1929; and much more recently, as I detailed in America’s permanent recession: Is it coming to Australia? (19 April 2022), many Americans still haven’t recovered from the GFC.
Fortunately, says Investopedia (“Investment Portfolio Strategy in a Recession,” 25 April 2023), “there are strategies available to limit portfolio losses and even log some gains during a recession.” These strategies reflect the two-fold reality: considered as a whole, equities’ market value falls during recessions; in contrast, certain debt securities (such as government bills and bonds) and gold appreciate.
Investopedia sagely concludes: “investors can’t hope to time a recession reliably, but diversification and measured steps to control risk can help preserve capital and position portfolios to profit from a recovery.”
Leithner & Company’s operations since 1999 have, broadly speaking, reflected this crucial point. And as conservative-contrarian value investors, we’ve added several twists and tweaks that further mitigate risk and enhance returns. As a result, and as I wrote in my previous wire (Are Australia and the US heading for severe recessions? 28 July), should they occur we “remain well-positioned for a severe economic downturn and a consequent sharp fall of equity markets.”
In response, Livewire contacted us and noted that “… there could be a good idea for a follow-up wire here … What do (well-positioned) portfolios look like and what are the assets suitable for (your) style …?” This article provides the requested follow-up. Since 1999 we’ve not dreaded bear markets, financial and other crises, downturns, recessions and panics: instead, our attitude towards these things has been stoic (see in particular Successful investors are stoics, 23 October 2020 and Investing lessons from Benjamin Graham, 1 November 2020).
That’s because we profit from downturns: in particular, our actions during the Dot Com bust, GFC and Global Viral Crisis have underpinned our outperformance over more than 20 years. These returns (see our web site for details) stem to a considerable extent from our preparations for and operations during inclement economic and financial weather.
How We Position Ourselves before a Recession
Most of the time – that is, before recessions, bear markets, financial or other crises, panics, etc. – we concentrate upon two key matters: (1) the overall “tilt” of our portfolio (i.e., its composition of equities versus non-equities); and (2) research and the resultant maintenance and implementation of our “buy and sell list” (i.e., the securities we’d like to purchase if their prices descend to our conservative valuations, and the prices at which we’re prepared to commence sales, if possible via “short positioning”).
These activities beget (1) an investment portfolio that generates steady and reasonable returns (but only infrequently outperforms) during rising markets, (2) the means to act decisively when markets steadily fall or suddenly plunge, i.e., acquire companies the prices of whose stocks have fallen significantly below our conservative assessments of their values, and thereby (3) outperform our benchmark over the long term.
In 1966, Paul Samuelson (who in 1970 became the first American to receive The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel (which is almost always misnamed as “the Nobel Prize in Economics,” and which had commenced in 1969) famously quipped: “the stock market has predicted nine of the last five recessions.” It’s also jumped at the shadows of bear markets, crises and panics.
Almost 60 years later, the ability to foresee economic and financial downturns hasn’t improved (for details, see Recessions usually crush shares – but investors can always reduce their ravages, 31 October). Perhaps that’s why Samuelson tartly added shortly before he died in 2009: “what we know about the global financial crisis is that we don’t know very much.”
Neither I nor you or the RBA or anybody else can reliably anticipate economic or financial downturns. How, then, to proceed? The key is that the intelligent investor is humble as well as informed. She knows what she knows – and frankly acknowledges what she doesn’t and can’t.
Although she knows the average longevity and severity of past recessions, she accepts that there’s simply no way to foresee when the next slump might occur, how deep it’ll be or how long it’ll last. She also knows that anyone who asserts otherwise is trying to fool others (and has probably fooled himself).
She acknowledges that an inverted yield curve is the most reliable precursor of recession – and that in this country and the U.S., this warning light is presently flashing red (for details, see Are Australia and the US heading for severe recessions? 28 July). Equally, however, she concedes this indicator isn’t infallible, and that overreacting incurs actual as well as opportunity costs.
Given this basic inability to predict the timing, severity and length of the next recession, since our inception in 1999 our portfolio has comprised, on average, approximately 50% equities and 50% non-equities. Moreover, the non-equities have typically comprised short-term and high-quality interest-bearing securities (see also How the 60/40 portfolio outperforms, 17 October 2022 and How we’ve prepared for the next bust, 28 November 2022).
Our weightings have varied considerably over the years. But as conservative value investors we’ve always faithfully followed Benjamin Graham. As he wrote in The Intelligent Investor, “we have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.”
It’s crucial to understand: such a portfolio doesn’t preclude short-term losses – whether they result from recession or anything else. Yet it greatly abates the frequency and severity of short-term negative returns, and thereby generates better and more consistent long-term results, than an all-stock portfolio. Above all, it sharply reduces the ravages of recessions.
Tables 1a and 1b quantify this point. Table 1a summarises my analyses of data compiled by Robert Shiller (S&P 500 and Treasury bonds), Federal Reserve Bank of St Louis (Treasury bills since January 1934), World Bank (gold since January 1960) and National Bureau of Economic Research (the unofficial but authoritative arbiter of American recessions’ beginning and end points). Corresponding Australian data have been available since 1969. Table 1b summarises my analysis of data compiled by Standard & Poor’s, RBA and World Bank.
Table 1a: Average Monthly Total Returns, Five Portfolios over Three Long-Term Periods
During the 1,830 months from January 1871 to June 2023, the total (that is, capital gain plus dividend) return of the Standard and Poor’s 500 Index averaged 0.64% per month. On an annualised basis, that’s (1 + 0.0064)12 = 8.0%. In contrast, 10-year Treasury bonds returned an average of 0.22% per month (2.7% per year), and a portfolio comprising 60% stocks mirroring the S&P 500 and 40% 10-year Treasuries returned an average of 0.47% (5.8% per year). Equities’ and 10-year bonds’ performance has been remarkably stable over these three long-term periods.
If the S&P 500’s average annualised return over very long intervals generally exceeds those of Treasury bills and bonds, as does the All Ordinaries Accumulation index vis-à-vis Australian Government bonds and bank bills, why should investors ever hold anything but equities? In short, and unlike equities, gold and interest-bearing securities don’t merely withstand the ravages of recessions: they benefit from them.
Table 1b: Average Monthly Total Returns, Five Portfolios, June 1969-June 2023
Five hundred and thirty-two of the 1,830 months from January 1871 to June 2023 have occurred within the intervals that the National Bureau of Economic Research, the arbiter of American recessions’ start and end points, has identified as recessions (“R” in Table 1a; non-recession periods are marked “NR”). That’s 29.1% of the time over the past 152 years. Recessions have marked 18.6% of the months since June 1926 and 13.3% of the months since June 1973.
Recessions have become less frequent over time; they’ve also become shorter. Crucially, however, as the years have passed they’ve tended to ravage equities ever more severely.
According to the NBER, on average since 1871 recessions lasted 17.2 months; this duration has shortened to 12.0 months since 1973. During the months in recession (as opposed to the pre-recession peak to recession trough) since 1871, the S&P 500 Index has shrunk an average of just -0.09% per month. For the recession of average length, that’s a loss of (1- 0.0009)17 = 1.5%. During recessions since 1926, however, the S&P 500 has shrunk by an average of 0.50% per month. That’s a loss of (1- 0.005)13 = 6.3%. And during recessions since 1973, the Index has shrunk an average of 1.00% per month. During the average recession, that’s a loss of (1- 0.01)12 = 11.4%. Recessions’ effect on Australian stocks is very similar.
Remember that these are average losses incurred solely during the months that, according to the NBER, have fallen within recessions: average losses from pre-recession peak to recession trough are much greater.
In sharp contrast, throughout all three of Table 1a’s intervals and also in Table 1b, 10-year bonds have, on average, not merely withstood recessions’ ravages: they’ve thrived during slumps. During months in recession since 1871, U.S. Treasury bonds have returned an average of 0.65% per month. Over the average (by length) recession, that’s a gain of (1 + 0.0065)17 = 11.6%. During recessions since 1926 and 1973, these bonds’ returns have also generated almost identical returns.
The Australian and American bonds and bills in Tables 1a-b tend to generate positive returns during recessions; consequently, in both countries the 60% stocks/40% 10-year bond portfolios better withstands their ravages.
During economic downturns over the past half-century , the American 60/40 portfolio shrinks an average of 0.35% per month; in the average recession over the past half-century, that’s a loss of (1 – 0.0035)12 = 4.1% – considerably less than the all-equities portfolio (for details, see How the 60/40 portfolio outperforms, 17 October 2022). This portfolio’s results in Oz are similar.
Twist #1: Bills versus Bonds
I’ve analysed data for 10-year government bonds because (1) they’re a benchmark and (2) it’s easy to access a very long series of valid and reliable data. Three-month Treasury bills and Australian bank bills also outperform equities during recessions.
Unlike the bills, however, these bonds are very sensitive to expectations about inflation, etc. These perceptions constantly change – sometimes abruptly. Consequently, they regularly generate MTM losses – sometimes large ones. Indeed, during the 12- month intervals to June 22-February 2023, they suffered their largest falls on record (10-17% in Australia and 12-18% in the U.S.). Much the same point applies to gold. For these reasons, they don’t provide the stable base we require for our short positioning operations (details below).
Accordingly, our holdings of non-equities have always been weighted heavily towards short-term (three-month and six-month) debt securities; seldom have we held longer-term bonds (and we’ve never owned gold or foreign bonds).
More generally, the conservative investor’s portfolio should usually (that is, during the ca. 85% of the time outside recessions) be weighted towards domestic, large- and medium-cap “value” stocks, and its bond component mostly comprise Australian Commonwealth notes or big four bank bills (or, and especially for DIYers and SMSFs, term deposits).
Twist #2: Our “Buy” List
During the intervals outside recessions, bear markets and the like, we also concentrate upon our research. Its purpose is to update our “buy list” (for example, the securities we’d like to purchase if their prices descend to our conservative valuations). That’s hardly unusual: most investors, ranging from major global institutions to personal investors of modest means, have developed a “circle of competence” (as Warren Buffett has dubbed it) and associated set of target investments.
In several respects, however, our list is unusual: most notably for this article’s purposes, we “stress-test” prospective investments against bear markets, financial and other crises, etc. In particular, we ask of each potential purchase: how did it fare during the recession of the early-1990s? The Dot Com Bust, GFC and COVID-19 panic? On that basis, how might it cope with the next downturn?
How We Adjust Our Portfolio during Recessions
Leithner & Company is a conservative-contrarian investor. Among other things, this means that we act primarily on the basis of our own research – and ignore the opinions of “experts.” Our research that’s relevant to this article produces three key conclusions:
- Recessions occur infrequently, and over the past 150 years (at least in the U.S.) they’ve happened even less often; arguably, however, over the past half-century their negative impacts have been increasing.
- Classes of assets such as equities, commodities (other than gold) and low-grade corporate (“junk”) bonds, whose returns rely relatively more upon economic growth, tend to underperform during recessions. Those whose returns rely less on growth (e.g., gold, government and high-grade corporate bills and bonds) tend to outperform.
- Experienced and humble (perhaps as a result of experience!) investors know that they can’t reliably foresee a recession in time to flee for safe harbours.
What, then, do we do during recessions (and bear markets, economic and financial crises, downturns, panics, etc.)?
The crucial point is that we virtually never sell shares. Quite the contrary: we add to our holdings (usually via “short positioning” – see below for details). As a consequence of the sale or maturation of non-equities and the purchase of equities, during recession equities’ percentage of our assets rises and non-equities’ share sags.
Cognitively, this is easy to understand; psychologically, for most people at crucial junctures it’s apparently insuperably difficult to practice. Tables 2a and 2b quantify this approach’s results. Since January 1973, and reflecting the generally high valuation and relative preponderance of technology “tera-caps” such as Apple, Amazon, Alphabet (Google) and Microsoft, etc., the portfolio that’s mimicked the S&P 500 has compounded, on average, 6.6% per year (including dividends) in “real” – that is, CPI-adjusted – terms over the preceding five years and 7.7% over the next five years.
If the final month of a five-year period wasn’t in a recession as defined by the NBER, then it compounded at 7.4% per year over the preceding five years and the same over the subsequent five years. Both retrospectively and prospectively, equities’ real five-year CAGRs generally exceeds 10-year Treasuries.
Table 2a: Average CPI-Adjusted Five-Year CAGRs, U.S., since January 1969
Although in Australia this result has applied intermittently, on average it hasn’t been true during the past half-century. The combination of deep recessions (such as those of the 1970s and 1980s), relatively high (compared to the U.S.) consumer price inflation during most of the past 50 years (which culminated in a CPI-adjusted compound annual growth rate (CAGR) of -20.5% per year during the five years to December 1974) and overall lower valuations have resulted in the outperformance of 10-year bonds during the average five-year interval since 1969.
If this result surprises you, you’re not alone: most “investors” overestimate both (1) their past results and (2) their likely future returns. Adjusted for CPI, during the five years to June 2023 the All Ordinaries Index’s total (capital plus dividend) return, expressed as a CAGR, is 0.13% (see also Why you’re probably overconfident – and what you can do about it, 14 February 2022).
Table 2b: Average CPI-Adjusted Five-Year CAGRs, Australia, since January 1969
A key result, however, is common to both countries. If the final month of a five-year period occurs during a recession (as defined by the NBER), then stocks’ CPI- adjusted, five-year CAGR over the preceding five years shrinks to just 1.5% per year in the U.S. and 0.4% in Australia. The recession, in other words, destroys most of the preceding five years’ returns. But during the subsequent five years, CPI-adjusted CAGR zooms to 9.3% per year there and 5.9% here. Bonds also rebound, but not as much as equities.
The implication is crucial: if during a recession you can mitigate your losses and add to your holdings of equities, then the slump provides a springboard to subsequent (five-year) outperformance.
That’s why during recessions we acquire more of the stocks we already own as well as those of the companies on our “buy” list; and we finance these purchases by selling or allowing non-equities to mature. The stocks we normally own – and thereby own when recession strikes – are those of large (mostly mid- or large-cap), reliably profitable companies with solid balance sheets and long track records of generating healthy cash flows and paying strong dividends. These companies are thereby better able than small-caps, heavily-geared companies, speculative stocks, etc., to weather downturns (see, for example, The myth of small-cap outperformance, 14 July 2023).
During downturns, recessions, etc., as and when our target companies’ prices relative to their values become compelling, we put our “buy” list into action.
Twist #3: Short Positioning ≠ Short Selling
When markets fluctuate without trend, and particularly during sharp downturns, Leithner & Company undertakes considerable short positioning – albeit ONLY in companies whose shares we wish to own as long-term investments.
It’s important not just to appreciate our operations’ very conservative nature, but also to distinguish them from short selling. People often use these two phrases loosely and sometimes interchangeably, but short positioning is not the same as short selling.
A transaction undertaken by means of a derivative contract is a short position, but it’s not a short sale because at the time the contract is instigated no tangible asset changes hands. Such “short positioning” transactions include futures, options and swaps. In particular, we often sell (“write”) exchange-traded options (ETOs) over certain companies’ shares, but we never buy them – and never short sell shares.
Premiums from exchange-traded options (ETOs) provide a significant percentage of our income (Figure 1). During recent financial years, dividends have provided the lion’s share (average of 47%). Realised capital gains have provided an average of 21%, premiums from the ETOs an average of 19% and payments of interest 13%.
Figure 1: Leithner & Company’s Four Sources of Income as Percentages of Total Income
Our ETO operations are extremely conservative: we always hold sufficient liquid assets such that if we were obliged to honour all of our obligations simultaneously then we’d be able to do so. These operations and the realisation of capital gains are inversely correlated: when markets rise strongly we tend to harvest capital gains but our premium income shrivels; but when they fall heavily our realised capital gains shrink or disappear but income from ETOs zooms.
Premium income from short positions doesn’t merely boost our income during downturns; in effect, it greatly reduces the already-discounted average purchase price of the shares we buy. This is another reason why we welcome (or, at any rate, don’t dread) downturns.
Conclusions and Implications
Recessions occur infrequently. It’s true that, using the Australian mainstream’s rule of thumb, almost 30 years passed between the recession of the early-1990s and the one induced by the COVID-19 panic. On a per capita basis, however, and especially when adjusted for CPI, Australians have endured several recessions over the past 30 years. Indeed, they’re likely experiencing one now.
Moreover, and considered as a group, bear markets, economic, financial and geopolitical crises, sundry downturns as well as recessions and panics are hardly uncommon. Leithner & Company doesn’t dread these events: if anything, we welcome them. That’s because our approach to investment enables us to profit from them. We’ve outperformed over the long term by being conservatively contrarian during booms and aggressively contrarian during busts.
Following these principles, since 1999 we’ve lost much less than most others during downswings. We’ve also recovered much more quickly than most others, and have taken advantage of the attractive valuations that occur; as a result, over almost a quarter-century we’ve outperformed.
Our conservative-contrarian approach extends to our conception of the business cycle – and thus of recession. “To every thing there is a season,” says the Book of Ecclesiastes, “and a time to every purpose under the heaven … A time to break down, and a time to build up; a time to gain … and a time to lose.” The business cycle encompasses downswings (recessions) as well as upswings (recoveries and expansions).
Just as all forests accumulate flammable debris, and healthy forests require occasional modest fires, recessions aren’t merely unavoidable: they’re also an essential and even salutary part of a healthy economy.
They undoubtedly cause hardship. Considered as a whole, however, consumers, investors and producers shouldn’t fear recessions, and central banks and governments certainly mustn’t try to avoid them. Instead, they should accept and even welcome slumps. The attempt to evade them – which has been orthodoxy since the Second World War, and has become extreme over the past quarter-century – eventually causes (as is evident today) even more people to suffer even longer and more severely.
A long stretch during which a government “successfully” suppresses recession is a time during which, in effect, back-burning is neglected and tinder accumulates: when the conflagration finally comes, it’s bigger than it’d be otherwise – and thus causes far more damage to property, and kills much more wildlife.
Why are recessions ultimately good for consumers, producers and society as a whole? When governments “stimulate” the economy and thereby try to suppress recessions, they enable outmoded and inefficient companies (“zombies”) to survive. Governments can’t pick winners – but like the barnacles that cement themselves to ships’ hulls, parasites invariably attach themselves to governments. Consequently, “stimulated” economies move less efficiently – and illogical and destructive ideas thrive.
A garden requires regular weeding and occasional severe pruning. Similarly, a flourishing economy requires what Joseph Schumpeter famously called “creative destruction.”
Recessions spur the salutary process whereby lean and hungry competitors displace fat, complacent and thus lagging companies – and sometimes entire outmoded and declining industries. The glory of capitalism is thus two-fold: (1) the many successes it creates, and (2) the many failures it terminates.
Just as exercise and sport are good for body, mind and spirit, recessions test business executives’ and investors’ mettle. Have you or your investments borrowed too much? Are their cash flows strong and reliable? Above all, do consumers really need or want what they’re selling?
Downturns induce producers and consumers become more conscious of cost, price and value. They thereby allow strongly-financed companies to expand and use resources more efficiently; by thinning the competitive thickets, they also provide opportunities to upstarts who’ve found better ways to provide existing and new products and services. Both of these processes boost productivity and eventually lift standards of living.
Recessions teach tough but much-needed lessons. They forcefully remind everybody that they must ultimately be realistic because they cannot afford delusions: fads never produce anything of lasting value, and crazes and manias always lead to disaster. Do ESG, the alleged “energy transition,” etc., make sense? Don’t they simply line insiders’ pockets at outsiders’ expense, and squander precious resources?
Why are recessions potentially good for investors? As we’ve demonstrated over more than 20 years, those who can mitigate their losses during the downswing will enjoy bumper returns during the recovery – and outperformance over the long term.
For conservative-contrarian investors like Leithner & Company, recessions are welcome: they return inflated valuations to earth; they consign a few (alas, far too few) of the mainstream’s many stupid and destructive ideas to the bonfire; and they pave the way for market-beating returns (for details, visit our web site, particularly the report “How We’ve Outperformed since 1999” on its Insights page).