News & Commentary

The art of balancing bad news 09 Dec 11

When we go through periods of poor market returns and extended volatility it is not surprising that the notion of market timing – sometimes cloaked in the more technical description of dynamic asset allocation – surfaces again.

So it is perhaps instructive to consider the situation in the US economy at the moment. While a lot of the focus has been on Europe and its debt crisis throughout 2011, the chances of the US sliding back into recession has been steadily increasing. Some US economists now believe the chance of a recession in the world’s biggest economy is now more than 50 percent.

Conventional wisdom says that is a signal for lower share market returns going forward – after all in a recession you expect to see depressed corporate earnings, higher unemployment and lower consumer and business spending.

So is it the time to go “defensive” with your portfolio?

A research paper released recently by Vanguard’s Investment Strategy Group has analysed returns for a balanced portfolio going back to 1926.

Co-authored by Vanguard chief economist Joe Davis and Daniel Piquet the research study – Recessions and balanced portfolio returns - set out to test the conventional wisdom that, faced with the prospect of a recession, investors may wonder whether to shift their portfolios to more “defensive” settings to minimise losses.

The study calculated returns on a hypothetical portfolio invested 50 percent in US shares and 50 percent in bonds under two distinct US business cycle regimes – recessions and expansions. The recessions and expansion periods were those officially defined by the US National Bureau of Economic Research.

The average annualised returns – both nominal and inflation-adjusted – were calculated for the balanced portfolio using monthly data from 1926 to June 2009.

There is a clear implication for conventional thinking coming out of the analysis.

This is because the average returns on a balanced portfolio over that span have been “similar regardless of whether the US economy was in or out of recession”.

This was particularly true of the inflation-adjusted returns because inflation tends to be higher during periods of stronger economic growth.

Indeed the average real return (i.e. adjusted for inflation) between 1926 and 2009 through was 5.26 percent during times of recession in the US compared to 5.59 percent return for periods of expansion.

That said, while the average returns since 1926 have been similar regardless of business cycle the returns for shares, bonds and the balanced portfolio have varied between specific recessions.

The average return results are clearly counterintuitive but the research suggests the similarity in average real returns occurs because of two often-complementary forces at work in a balanced portfolio.

When the likelihood of a recession is rising or imminent there is a tendency for bonds to outperform stocks during the initial period of weakness – the so-called “flight to safety” effect.

Secondly, share prices tend to decline before a recession officially begins and to rise before the recession is officially ended – the sharemarket being in effect a “leading” indicator.

As the research highlights, that should not be surprising because since 1926, 10 of the 20 highest returning months on the US sharemarket have been during recessions and 7 of the top 10 performing months have been when the US economy has been in recession.

Past performance is just that. So the average historical return of a balanced portfolio during past recessions should not imply that if the US slips into recession later this year you should expect similar returns. Other measures like current sharemarket valuations and bond yields need to be considered as well.

It is understandable that investors may feel tempted to take defensive action because of concerns about the possibility of a US recession.

What this study points to is the higher-level need for investors to have an asset allocation that matches their risk tolerance and long-term objectives.

And while a 50/50 portfolio will not be appropriate for every investor it does illustrate how taking a balanced, well diversified approach has weathered past periods of recession.

It also points to the many obstacles investors face in trying to time defensive investing moves because even the best signals of bear markets are low when it comes to predicting future returns.

Finally, attempting to time market moves comes with the hidden or perhaps underappreciated risk of being out of the equity market when the bad times end.

* Written by Robin Bowerman, Principal, Corporate Affairs & Market Development at Vanguard Investments Australia.
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