How to Trade a Recession

The US economy is going to slip into a deep recession in 2023 with high (and steadily rising) probability. But, at the same time we can say with confidence that we are not in a recession at the current moment. By now this assessment of the economic trajectory is as much of a “sure thing”, as we are ever likely to get in a field that is as fluid and uncertain as finance and the economy.

Can we take advantage of these facts, if we take past US recessions as guidance? Are there practical opportunities that we can profit from hidden in the data?

If you concur with my base case, you can skip over the data I present to support it and go straight to the practical implications.

Two key puzzle pieces for the current Economic assessment

a) We are not in a recession now.
The official scorekeeper NBER defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”  While we did see a falling GDP over the first two quarters of 2022, it is highly unlikely that this is sufficient to qualify as an official recession given the simultaneous strength in employment, personal income, housing, and so on.

One practical problem that we will have to deal with is that the official NBER verdict is usually delayed by several months. As recessions tend to be short (10 months on average), we may already be in the last inning by then. However, NBER is not the only one who assesses the state of the economy, and it will probably be a clear case by the time it is going to be most relevant. A helpful model that uses the main NBER criteria is published on the FRED website and nowcasts recession probabilities with minimal delay (1-2 months due to data availability).

A recession nowcast model sees no US recession in September 2022; FRED

b) There will be a US recession within the next 12 months.
A plethora of indicators currently points to this, but because they can easily be cherry picked and even the most reliable indicator will fail some of the time, I present the data from several excellent recession prediction models. They all use several inputs, and the current confluence of many fundamental warning signals across the board tilts probabilities strongly in favor of a deep US recession in the near future.

Bloomberg’s recession model uses 13 different inputs to calculate recession odds over the next 12 to 24 months; via Macro Ops
The Conference Board’s Leading Economic Index (LEI), which uses 10 leading fundamental indicators, points to a recession with 96% probability.
The SentimenTrader Macro Index uses 11 indicators to position a portfolio risk-on (green) or risk-off (red), if a recession is anticipated.
IndicatorLEI10-Year Minus 3-Month TreasuryUnemployment RateInitial claimsRetail salesFinancial Conditions
Warning if6mma RoC < 0T10Y3M < 0Rate > 12mma12wma > 52wma6mma RoC < 0> 0
The fundamental leading indicator status of my own Meta Strategy. I did a lot of research on this and therefore I trust it most.
The confluence of 5 out of 6 indicators signaling a coming recession is very strong and rare.

How to trade the coming recession?

So, how does this matter, as the stock market is not the economy and all that?

Despite displaying a wide range of outcomes, there are a few very useful commonalities in the behavior of the US stock market during recessions. On average recessionary bear markets last longer (14 months) and drop deeper (-41%) than bear markets outside of recessions. They also represent a very rare opportunity, as the current bear market will likely qualify as only the 14th recessionary bear in almost a century.

Recessionary bear markets tend to be deep and long; Stansberry

The key commonality

Historically, the lowest stock market low was always made within the actual recession period – never before, hardly ever after.

The likelihood to encounter the low is highest roughly in the middle of a recession; Deutsche Bank

Two major opportunities

Given our base case this points to two medium-term trading opportunities, because the bear market low is likely still to come and, once there is widespread agreement that we are in a recession, the start of a new bull market will be very close.

a) The final selloff:
Before the eventual rise from the ashes, recessionary bear markets tend to go through a prolonged bottoming process, which usually doesn’t find its final low until a recession has already started. Therefore, a final selloff is still to come, which jibes with the bear market averages pointing to a low in the vicinity of 2900 for the S&P 500 in Q1 of 2023. This is supported by the average signal lead times of the most reliable leading fundamental indicators. (Bearing in mind a wide range of possible outcomes around the averages!)

The current relief rally provides a high probability entry with very good reward / risk to short the market for this scenario.

Two additional pieces of evidence support this idea: Valuations have not come down sufficiently and there have not been signs of real capitulation during this relatively orderly bear market so far. These final pieces do not necessarily have to fall into place, but history suggests that they most likely will.

In a final leg down stock market valuations are likely to reset below average, which is a general setup to look for rather than a timing tool; BofA

Looking for peak panic during the next selloff is more useful than valuations when trying to pinpoint a market bottom, as there is a diverse set of data points and market studies to look at for signs of final capitulation in comparison to similar past occurrences (I will closely follow these indicators in my weekly subscription report once the time comes). The key ingredient for this process will be widespread panic that causes buy-and-hold investors to finally throw in the towel and release a large wave of selling – a telltale sign should be a spike in volatility and a sharp drop in household equity allocations.

b) The start of the next bull market:
The chart below clearly shows that bottoms occur on average after recessions start, but before the economy recovers – the stock market is forward looking. It also gives us a useful timing average for the bottoming process: The ultimate low within a drawn-out bottoming process commonly occurs between 2 – 6 months into a recession, which last between 2 – 18 months historically.

The best opportunity to build a long-term stock portfolio hides smack in the middle of the coming recession – just when the outlook is going to be at its bleakest and putting money to work will be most difficult.

There is no reason to fear missing the absolute low, because from a long-term perspective anytime from the start of the recession to a full 10 months into it will serve as an excellent entry. Recessionary bear markets are very rare opportunities!

The optimal entry – with the highest average one-year return of all stock market periods – would be 1/3rd to 2/3rds of the way into a recession, which will be very difficult to pinpoint considering the wide range in duration past recessions have had. Apart from looking at signs of capitulation to narrow down the time frame, a safe method (which I employ in my investment portfolios) would be to wait for a confirming trend signal after the bottom – for example, a moving average cross over.

FED Pivot

Much talked about in the media is the prospect of a stock market turn-around brought on by a FED pivot that stops the steep interest-rate-hike cycle. (Fueled by last week’s positive CPI surprise this hope is what is driving the current rally.)

One stat is clear enough, however: Bear markets have never bottomed, while the FED was still hiking interest rates – and by all accounts we are still a couple of rate hikes away from a likely pause.

Be careful what you wish for! The current market environment (high inflation + stable employment) will likely only lead to a change in the FED’s hawkish stance when something serious breaks, and a recession becomes inevitable.

But once their policy throws the economy into a deep recession, even a decisive FED pivot is likely to lead a stock market selloff and the bottom by several months. A pivot is only an immediate savior, if it comes early enough to avoid a recession in the first place.

There is no FED Put in an inflationary regime.

Addition: NBER Announcement dates

While the S&P 500 has never bottomed before an official recession begins, it has often bottomed before an official recession is announced. Actually, since 1980 NBER announcement days make for excellent entry dates to build a long-term stock portfolio – the biggest outlier was in 2001, when another leg down followed both recession and announcement.

Good luck with your trading, and thank you for reading!


This is not financial advice.
These are my own views, as I will likely implement them in my own portfolio.
Please do your own due diligence!

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