The Sahm Rule and an Upcoming Recession?

In a previous post, I explained the history and use of the Sahm Rule, a recession indicator named after economist Claudia Sahm. The Sahm Rule compares current unemployment to the previous 12 month average.

The rule is an early indicator of a recession, and it has accurately predicted every recession since 1960 with only 1 false positive in 1976. Even though the rule failed to predict a recession in 1976, it did accurately predict a 25% fall in the S&P 500.

As of this past Friday, the Sahm Rule has once again triggered, perhaps indicating that a recession is near.

While some investors and market commentators want to brush off the indicator, saying that the increase in unemployment is due to the expansion of the labor market, I am more skeptical. I think there are numerous signs that a recession could strike within the next year:

1. The Sahm Rule: In general, it’s folly for investors to rely on “this time is different.” Usually “this time” is not different. If a highly accurate indicator suggests a recession, it is probably correct.

2. Inverted Yield Curve: The yield curve has been inverted for over a year now. While this is a less reliable recession indicator, it has flashed red for some time now.

3. Notable earnings misses: In the most recent earnings cycle, there were several concerning earnings reports. While these could be isolated incidents, taken together they suggest a weak American consumer:

   1. Tesla: Tesla reported weaker-than-expected profit numbers, suggesting that they had to offer deeper discounts to meet topline revenue goals.

   2. Airlines: Numerous airlines have reported needing to cut ticket prices in order to fill seats.

   3. McDonalds: McDonalds reported a year-on-year revenue fall, the first time since Covid that this has happened.

Having said that, I expect any recession to be relatively mild. I don’t see the recipe for a major financial crisis, and the Fed has ample tools to ease conditions on consumers. If a recession were to start, the Fed would likely cut interest rates, thus increasing the value of bonds. This would shore up bank balance sheets and consumer borrowers. It should help to prevent a financial crisis while also encouraging consumer spending.

What investors should do

Given that we might face a mild recession, how should you invest? In general, you should stay the course. However, now is a good time for all investors to review their portfolios and discuss options with their financial advisor.

First, confirm your risk profile

Investors should review their portfolios and assess how much they could fall in a recession and how long it might take to recover.

For example, in 2001, the S&P 500 fell 42% from peak to trough, and in 2008 it fell nearly 50%. In 2001 and 2008, even a diversified portfolio with 10% bonds took 3 years to recover.

Investors should look at their equity investments and confirm that they can stomach a 40% loss and could go 3+ years without needing to draw down on those accounts.

If you feel like you could not handle that performance, then you should consider holding a lower risk portfolio, namely one with more bonds or money market funds.

For higher risk tolerant investors, consider rules-based trading

If an investor has a high risk tolerance and views a possible recession as an opportunity to acquire some equities for cheaper, they could adopt a rules-based approach. This approach attempts to time the markets, which is inherently risky but can increase returns. Below is an example of 2 rules that an investor could use:

1. Reduce your equity allocation by 20 pts if the Sahm Rule triggers. Hold bonds or money market funds instead.

2. Move back to your original equity allocation after one of the following happens:

   1. The S&P 500 falls 25% from its peak: time to grab those discounts.

   2. The S&P 500 grows 15% from its recent peak: Something went wrong and a recession didn’t happen, time to get back into markets

   3. OR the Sahm Rule un-triggers for 3 or more months:

Rules-based trading is one way to slightly increase returns by taking advantage of discount investing options at the bottom of a recession. In essence, it allows you to buy stocks at a 25% discount. This approach should only be used in very long term investment accounts, and it’s best done in tax-deferred accounts to eliminate taxation costs.

In accounts where you anticipate needing capital in the near term, you should stick to a lower risk portfolio and stay there, not try to time markets.

In accounts where you would face a substantial tax burden from selling equities, it’s probably better to hold until you need the money. Taxation is a guaranteed loss, whereas investing in this manner only has the possibility of gain.

Meet with us

If you are a current client, you will receive a separate email with a custom analysis of your current portfolios and exposure in the event of a recession.

If you are not yet a client but want to talk to a financial advisor, let’s meet soon! At Toups Capital Advisors, we help clients design an investment portfolio and financial plan based on their goals and where we see markets heading. Contact us today to schedule a free consultation.

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