By: Reed C. Fraasa, CFP®, AIF®, RLP®
Shakespeare wrote ten dramas, each with a different story and cast of characters. However, his tragedies follow the same five-act formula: Exposition, Rising Action, Climax, Falling Action, and Resolution.
Every play, movie, and television drama from Shakespeare's time to today follows the same five-act sequence. Our culture's art and entertainment reflect our innate expectations of the hero's rise, fall, and resolution. Likewise, our expectations for the economy and financial markets are no different.
Today's current economic cycle is like a Shakespearean five-act drama, a five-act financial play - a different cast of characters in different situations but the same economic cycle we have seen over and over again. Yet, I've heard many people say that things are different this time, and it is worse than ever before. We are in the middle of the second and third acts of the economic cycle, and there will be a recovery.
Can you imagine watching a play or movie introducing characters and their circumstances, followed by a conflict heading to a climax, only to end the story in the middle of a climactic crisis? There is always a falling action and resolution, even in economic cycles.
The chart at the bottom illustrates the stages of a recession. Framing the current economic cycle in a dramatic plot structure may help clarify where we are in the story and that we can look forward to a resolution.
Exposition
Where we were before all this started, last November 2021, the economy was recovering from the pandemic and improving, the stock market had rallied, and most portfolios peaked during November.
Rising Action
The first quarter of 2022 introduced two characters, inflation and the Russian invasion of Ukraine, the latter causing an energy and food crisis.
The second quarter of 2022 introduced new plot elements, a rise in mid-term election hyperbole and several mass shootings, plus more inflation.
The rising action was all the bad news conflating and causing a significant increase in uncertainty. Traders' and investors' expectations diminished, and more sellers than buyers of assets existed.
Climax
The federal reserve targets inflation with an aggressive rate hike policy that will eventually slow down growth, increase unemployment, lower wage growth, and reduce inflation—the characteristics of a recession. The bottom of the recession is somewhere in the trough.
Uncertainty begins to diminish – a negative outlook is inevitable.
Falling Action
The effect of a recession brings down inflation. The federal reserve slows down rate hikes and may eventually start talking about rate decreases. Traders expect corporate earnings to improve.
Valuations look cheap, and the stock market responds favorably to the positive news.
Resolution
Short-term rates, controlled by the federal reserve, return to 2% to 3%, inflation returns to an average of 2% to 3%, unemployment is about 4% to 4.5%, and the intermediate bond market settles in at about a 4% to 5% yield. The stock market is nearing a full recovery. The preceding is not a prediction but a probable outcome of a soft economic landing.
Although the preceding hypothetical economic plot line is the typical scenario, timing the transitions of the acts is extremely difficult and improbable to do consistently. The table in the chart below shows the average monthly returns for the seven prior recessions from 1973 to 2021.
What is surprising is that a recession has two parts. The first part is the falling action with uncertainty and tension increasing. Not surprisingly, the average monthly returns are negative. The current economic cycle has had similar average negative returns for the past eleven months.
Selling out of financial assets when uncertainty is high, and values are down, intending to buy back in at the bottom, is only justified if you know when the herd of investors will start buying. By the time the climax of the cycle happens (the second half of the recession), the stock market has already been averaging significant positive returns.
Waiting to buy back in until after the falling action or resolution passes risks missing the best days in the stock market.
We cannot predict when the bottom will happen or when smart money will start buying back into the market, but we know this is the same old story with a different cast of characters. It only feels different this time.
Patience and seeing the next few quarters as an opportunity to buy in with any surplus cash above your financial planning needs for the next five years is prudent.
Data from 1973 – 2021. The market is represented by the CRSP U.S. Total Market Index. Source: Avantis Investors. The average number of months over the period from Peak to 1/2-Trough and 1/2-Trough to Trough is 5.4, while the number of months over the period from Trough to 1/2-Peak and 1/2-Peak to Peak is 35.9. Past performance is no guarantee of future results.
The foregoing content reflects the opinions of Highland Financial Advisors, LLC, and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will act as they have in the past.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.