Pundits and forecasters have an awful record of predicting exactly when and how bad recessions will be. But it is possible to know when the risk of recession is much higher than normal. Here's how to tell and what to do about it.
(Usual disclaimer: I'm just an investor expressing my personal opinion and not a financial advisor, attorney or accountant. Consult your own financial professionals before making any financial decisions. Code of Ethics: We do not accept any money from any sponsor or platform for anything, including postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members.).
This is part three of a four part series on the most important real estate cycles:
Why care about recessions?
A recession is one of the most dangerous things that can happen to your real estate portfolio. First, a recession is the last phase of the physical cycle, which drives down your rental income. And if the investment is funded with debt (as most are) there's a risk it won't be able to make the payments. If this happens you can go bust and lose everything.
A mere physical cycle recession is actually often pretty mild. The double whammy is when a financial cycle downturn is happening at the same time as a physical cycle downturn. That's when we get a severe recession like the Great Recession. Prices can fall dramatically and stay that way for a very long time (sometimes a decade or more). This makes it very hard to exit without losing money, and also increases the risk of not being able to pay the debt and defaulting.
So it would be great if we could know exactly when and how bad the next recession will be. And lots of people claim they know this. Unfortunately, studies have found that it's pretty much impossible to predict the exact timing of economic events (and their severity) more than 12 months ahead.
This fact doesn't stop all the pundits from telling you the "answers" anyway. For every forecaster claiming a recession is obviously imminent because of reason 1, there's another claiming there's no way we'll see one for years because of reason 2. And for every forecaster saying the next recession will definitely be a doozy for reason 3, there's another one saying that it's going to be very mild because of reason 4. I personally find all of this extremely unhelpful and un-useful.
Fortunately, it is possible to look at things in a different way. Instead of trying to predict what the economy is doing one to five years from now, it is possible to look at how the economy is doing right now. And if the chance of recession is higher or lower than normal, I can tilt my portfolio accordingly.
There are hundreds of thousands of economic indicators published by the government, and several have a good history of providing "canary in the coal mine" warnings. When lots are flashing yellow or red, I hit the brakes and position myself defensively (or very defensively).
Yes, it's not perfect. I do run the risk of braking too early (or maybe even for no reason at all) and leaving profits on the table. But as a conservative investor, I'm fine with this since my first priority is preserving my capital and avoiding losses. And even if I'm too cautious, I know that I won't be tapping on the brakes forever. Eventually there will be a downturn and recovery, and all the lights will be flashing green. That's when I feel alot more comfortable cramming down the accelerator.
First, I'll talk about about a not-very-good indicator. And then I'll talk about some of the good ones.
A lousy indicator: The stock market
We recently had a 10% correction in the stock market and this has most people worried. Many believe that the stock market is a good indicator of an upcoming recession. However, this isn't true and it actually has a pretty unreliable record.
First, mere corrections aren't very good at predicting recessions as bear markets (i.e. 20% or more loss). So we are not there yet. (Since 1950, only 9 of the last 25 corrections actually turned into bears, with 16 false alarms).
But even if we do get a bear market, the reliability record isn't that great. Since 1950, there 9 bear markets. 3 out of 10 recessions occurred without a bear market beforehand. And there were 3 (out of 9) other bear markets that were false alarms that occurred without a recession.
So if and when we get to a bear market, I would take that as a potential yellow light. But I would like to see some other indicators also verifying that there is a problem.
Yield curve inversion
The yield curve is the difference between the interest rate on the 2 year treasury and the 10 year treasury. Normally, the 10 year treasury has a higher interest rate because there is more risk in holding something for a longer term than shorter. But every once in a while, something strange happens and investors demand a higher interest rate for the shorter two-year treasury. Economists do not agree on exactly why. But the bottom line is that since 1967, every recession was preceded by an inverted yield curve, and that recession followed one to three years later. (Although there have been a few early/false alarms).
Note: a 0 on this graph=inversion.
Currently, there is no inversion although it is getting very, very, very close (the closest since the great recession). Here is a closeup:
So this is a late cycle signal and makes me cautious.
There's been a lot of press about the fact that the 3 year and 5 year treasuries have inverted, which is something that precedes many recessions.
The 3 year/5 year inversion does not have as good a record as the 2/10 as it has also had quite a few false alarms (5 out of 11 or 45% were false alarms since 1969). However, as you can see above, it has had plenty of hits as well.
I do feel this is another late cycle signal and bears closer watching. I am now on a 2/10 yield curve inversion "watch". We'll see what happens in early 2019 and beyond.
Note: Japan "broke" this indicator on their own economy when they started quantitative easing. And here in the US the Federal Reserve has not fully unwound our own quantitative easing. So some are worried that this indicator may not trigger this time around. So I won't view the lack of an inversion as a green light, as some people do.
Unemployment (four-week moving average)
This indicator has done the same thing for every cycle since at least 1970. It hits a low and then starts climbing. When that happens, a recession starts anywhere from 0 to 3 years in the future.
Currently, we are still in the downward trend. So currently this is green. However as you can see above, it can change extremely quickly as it did in the last recession. Everything was fine and then suddenly a few months later it rose a tiny bit and a brutal recession hit. So it's hard for me to feel too comfortable about this indicator, even when it's currently okay. And I keep an eye on it closely.
These are permits for building new houses. Since 1958, every economic cycle but one has had a peak and then a 10% drop before the recession. (The false alarm in the 1980s was during the slow-motion S&L crisis).
Here's what this looks like right now:
So far this is still green, although we have not had a new high since May. So this may be drifting toward yellow. If we hit a new high in the next few months, I would take that as a great sign. But this may be hard with rising interest rates. If it doesn't, then this could eventually deteriorate and become a problem. Again I am keeping an eye on this one.
Late Cycle strategies
So at this point, I don't see any red flags showing that a recession is about to happen tomorrow. However, I do see lots of signs that we are very late in the cycle. And I feel it is very evident that there is more risk than usual.
And many real estate deals run for multiple years. So by the time the signs are evident, it may be too late to act. I don't want to be caught in a pickle. So as a conservative investor, I'm preparing myself now for what will eventually come.
Leverage: I greatly prefer low usage of debt to high. I won't go more than 65% loan to value (LTV). And if I can go less (for example Broadstone Net Lease at 40% leverage, or my own portfolio of rental properties at 0%, then I'm very happy to do that.
Risk reduction: I invest larger amounts of my portfolio in no-leverage debt funds (like Arixa Secured Income Fund) and smaller amounts in leveraged equity funds.
For the ultimate protection, I am looking to diversify my alternatives portfolio into investments that are not tied directly to the business cycle.
For example, life insurance settlement funds pay when someone passes away. So it doesn't matter what the economy does (and maybe arguably they might do a little better in tough times). And this particular fund is the most experienced sponsor with the largest diversified portfolio in the industry. (More...)
The next article in this series is about analyzing the local market cycle. See Real Estate Cycles Part 4: Where are we in the local real estate cycle?