Last October I wrote an important Orcam Research piece that described why recession forecasting can make a big difference. Not only are recessions important in understanding future policy (since high unemployment tends to result of recession, but from the perspective of portfolio management, recessions tend to be when the worse loss of capital occurs.
Now, if one is able to build a cyclical model that helps decipher when recession probabilities are high, you can protect your portfolio from the periods when the market is at the highest risk of resulting in a permanent loss environment. Likewise, calling a recession when one is unlikely to occur, results in being out of the market during a strong likelihood of gains. Obviously, anyone who has been out of the market over the last few years has suffered from this.
Anyhow, it was nice Bill McBride at Calculated Risk elaborating on this point in a weekend post. Like me, he was not calling for a recession in 2011 or 2012. I call this “getting the direction of the tide right”. In the macro world, if you get the direction of the tide right you’re very likely to look like a pretty good swimmer.
Anyhow, here’s more from Bill (via Calculated Risk):
“Imagine if we could call recessions in real time, and if we could predict recoveries in advance. The following table shows the performance of a buy-and-hold strategy (with dividend reinvestment), compared to a strategy of market timing based on 1) selling when a recession starts, and 2) buying 6 months before a recession ends.
For the buy and sell prices, I averaged the S&P 500 closing price for the entire month (no cherry picking price – just cherry picking the timing with 20/20 hindsight).
The “recession timing” column gives the annualized return for each of the starting dates. Timing the recession correctly always outperforms buy-and-hold. The last four columns show the performance if the investor is two months early (both in and out), one month early, one month late, and two months late. The investor doesn’t have to be perfect!”