The Dow Jones Industrial Average just experienced its two biggest one-day drops in terms of points in one week. The Dow fell 1,175 points on February 5, 2008, and it fell again 3 days later on February 8, 2018 by 1,033 points.
Of course, this was starting out at a level above 25,000. In percentage terms, it comes nowhere close to matching the October 27, 1987 crash (Black Monday) when the Dow fell by over 22% in one day. It was a fall of 508 points.
Stocks had recently been on an upward trend for quite a while without any kind of significant pullback. From that perspective, it shouldn’t have come as that big of a surprise. The lack of volatility changed quickly.
The first question is whether this is the start of a new bear market (usually defined as a 20% or more drop), or simply a small blip before things turn up again. I don’t claim to have the answers here, and you shouldn’t trust anyone who is 100% sure that he does have the answers. That is because it is all based on human action. We cannot accurately predict how millions of people will act each day. We can make good guesses based on the conditions, but timing predictions are virtually impossible.
What I do know is that the Fed had an extremely loose monetary policy from 2008 to 2014. Since then, it has kept a relatively stable money supply in terms of the monetary base. According to the FOMC implementation notes, the Fed is slowly draining its balance sheet now. This points to an eventual recession, as the previous misallocated resources become exposed. It becomes evident that there is not adequate savings and demand to sustain certain longer-term projects that previously looked like a good idea when there was a loose monetary policy and lower interest rates.
There is little question that part of the gains in stocks is related to the previous loose monetary policy. Sure, stocks were likely oversold in 2009, but they have run to almost ridiculous levels today.
Another major question is whether a bear market in stocks automatically implicates the economy going into recession. This was definitely the case in 2008. While the official recession was backdated to late 2007, it did not become evident until September 2008. This corresponded with a massive fall in stocks. Did the falling economy tell investors to sell stocks, or did stock sellers tell everyone else that we were in a recession? The answer to this isn’t even clear.
Still, I do think it is possible that stocks could fall dramatically without necessarily plunging the entire economy into recession. Look at what happened to oil in 2014 when it fell from over $100 per barrel to eventually under $30 in 2016. Yet, everything else did not come crashing down. There was one asset bubble that popped without everything else popping. You can blame this on shale oil and increased production, but you can also blame an over-inflated stock market on exuberant investors in search of yield. It doesn’t necessarily mean everything else has to go down with it.
If stocks keep going down, I certainly think the chances of a recession become greater. It is a sign of weakness. However, another consideration is the yield curve, which is still far from inverted. An inverted yield curve is the biggest recession indicator, but long-term rates have been going up slowly with short-term rates. We would really have to see at least a somewhat flattening of the yield curve before we are likely to see a major recession. I suppose there is a first time for everything (a major recession without an inverted yield curve), but why start now?
Either way, it should not change your strategy in how to deal with either situation. I recommend you have a majority of your financial assets in a permanent portfolio setup to weather any kind of storm.
If we hit a recession, the most important thing you can do is to protect your main source of income. For most people, this is their job where they earn a salary. You should avoid being on a short list for being fired, but this is good advice in any economic scenario. It is also best to avoid being with a company that can easily go bankrupt, but it may be a little late to fix that now.
The average American actually needs a good hard recession to clear out some of the previous malinvestment. It will make life more affordable in the longer run. The problem is that part of the reallocation will mean an increase in unemployment and likely lower nominal wages. This is necessary as part of the correction process, but certainly painful.
Our biggest fear should be the response of the Fed in the next recession. If the Fed starts another round of massive monetary inflation, then hard assets like gold will become one of the best financial investments. Until then, cash is still king.