The Economy, Markets, and Your 401(K) Portfolio, Pt. 2 of 4

In our inaugural edition, I began with a focus on retirement plan investing by emphasizing the importance of asset class diversification and pairing investments with economic cycles to achieve a suitable risk-adjusted return.

Understanding Economic Cycles

Where exactly is the economy heading? That's the question on the minds of most investors who are concerned about the performance of their retirement plan assets. Investor behavior is often influenced by two emotions: greed and fear. It takes wisdom, patience, and discipline to routinely make profitable investment decisions. Before starting my career as a Financial Consultant with A.G. Edwards & Sons, Inc. in 1999, I hired an older gentleman to serve as my financial advisor. He gave me some advice that I remember to this day and have shared with many of my clients throughout the past 30 years.

He said, "Martin, timing the market is not as important as time in the market!" What sage advice that was, but it was lacking some important context. The obvious question is why is time in the market more important than timing the market? Had I asked this question and he answered me with "because over time the market will improve", "what goes down must eventually go up", or "because bear markets are often followed by bull markets." Either one of those answers would have been insufficient and wrong! Thankfully, he didn't give me such an answer. He didn't provide an answer at all, except to repeat his favorite saying that 'time in the market is better than timing the market.'

Caveat: For the novice, I believe that this statement is true, for the most part. However, for a seasoned investor with years of experience, timing the market is just as important of a skill as buying quality stocks and holding for the long term.

A few years later during the "Y2K Recession", I learned why time in the market is better than timing the market and it has everything to do with how the economy works, i.e. economic cycles. The economic cycle is also referred to as the "business cycle" and it usually follows a defined pattern of:

1. Peak
2. Recession
3. Trough
4. Recovery
5. Expansion
6. Peak - and this progression repeats with Peak.

I stated that the usual pattern of the economic cycle is as illustrated above because there are times when the business cycle may be influenced by a particular crisis such as a war, pandemic, widespread corporate malfeasance (e.g., such as with the Great Recession), etc. During such instances, known as "event risk," the markets may experience a sharp decline for the day, week, month, or even longer. However, it is important to be able to discern whether a particular type of event risk is economically impacting, or not. [I will address the importance of discerning event risk in the next edition.]

The business cycle is influenced by many factors, corporate earnings, inflation, fiscal and monetary policy, employment, etc. For example, when the economy is experiencing a period of "expansion" real gross domestic product (GDP) grows for two or more consecutive quarters. Expansion is marked by a rise in employment, consumer spending, and subsequently an increase in equity markets. When the economy is experiencing a "peak" this is when the business cycle is at its top and it is the period between an economic expansion and the beginning of a contraction (i.e., recession) in the economy. The peak occurs before a decline in economic indicators such as employment, new housing starts, and GDP. By contrast, the lowest point of the economic cycle is the trough, marked by the period following a recession.

While it is important to know where the economy may be at any given time, it's also important to understand the cause, not just the effect. For example, when the economy is experiencing a time of recovery, followed by expansion and peak, corporations are usually earning nice profits during this period. Also, consumers tend to spend more as people feel wealthier and prices of goods are also rising. In other words, inflation is beginning to move higher. Eventually the Federal Reserve, in an attempt to bring inflation lower, will increase interest rates over some time, 1 or 2 years.

After a period of "tightening" by the Fed, GDP will decline and what usually follows is a rise in unemployment as layoffs increase. After two consecutive quarters of negative GDP, the economy has officially entered the period known as recession. Likewise, when the Fed feels that inflation is "in check" (the Fed has a target percentage number where they would like inflation to fall to, such as 2% from a previous high of 7% or 8%) they will reduce interest rates, which increases new housing starts (i.e., "home buying") and employment usually increases as companies begin hiring once again.

While economic recessions are usually loathed by investors, this doesn't have to be the case. Why? because for the investor who understands which asset classes tend to perform well during a recession, it is possible to make money during these times of economic decline. This is why it is critically important to understand how to pair economic cycles with asset classes, as I stated in our inaugural edition of "The Economy, Markets and Your 401(K) Portfolio." I will say it again, this time more emphatically, YES!!! YOU CAN MAKE MONEY DURING A RECESSION. NO!!! YOU DO NOT HAVE TO LOSE MONEY DURING A RECESSION.

At times, listening to financial and economic analysts talk about the economy can be as boring as watching paint dry. Depending on who the commentator or analyst is, you may be in for a long, dry-as-all-get-out, boring listening session. But I would encourage you to eagerly listen because that is how you are going to develop an understanding of the economy, strengthen your sense of discernment, and be able to confidently (and correctly!) know which season of the economic cycle we're in, and more importantly where the economy may be heading.

This is how you will begin to develop a level of proficiency that could result in positive investment performance within your 401(K). But don't start whistling Dixie yet because we still must discuss how to properly pair asset classes with the five sessions of the economic cycle, including that strange economic outlier, known as Event Risk.

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‍In Pt. 3 of our next edition of "The Economy, Markets and Your 401(K) Portfolio", we will look at Event Risk,

its potential for impacting the economy vs. the markets only, and prudent steps to take during these times of economic and market uncertainty.

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