Whether you believe recession is here, is coming, or we will avoid it, you need to make sure your finances are prepared for market downturns.
As I sit down to write this piece, a very windy storm is brewing outside my window. It portends something many of us feel: that winter is coming.
The 2023 U.S. economy is not going smoothly. Compounded by chaotic events internationally, our current market cycle, and a possible recession, it can be very stressful for those of us trying to build a successful financial life.
My role much of the time is to stay out of the fray—to avoid commenting on short-term upheaval in a way that makes me sound more informed or knowledgeable than I am. To be clear—no one is informed or knowledgeable when it comes to large economic shifts. The shifts happen and “talking heads” explain it in hindsight—referencing already occurred events and data. (If this were not the case, these experts would be on their private island, not CNBC.)
Signs of Underlying Economic Woes
Signs of an economic downturn are popping up throughout the economy:
Inflation
Inflation continues, albeit at a potentially slower pace. The cost of necessary goods has already gone up enough to significantly impact the lower-and middle-class households.
Business & Personal Bankruptcies
Business bankruptcies have increased 68% for the first half of 2023, and individual filings have gone up 23%1—a pretty massive increase. Increased bankruptcies are a sign of large-scale problems in the economy.
Credit Delinquencies Rising for Credit Cards & Auto Loans
Driven by rising interest rates and other economic factors, consumers are starting to miss payments on household debt at increased rates.2 This is a significant sign that household income/cash-flow is being impacted by market trends such as the increased cost of goods.
International Conflict
And as of this writing, international events are posing a challenge to peace, security, and world markets. Several obstacles globally include:
The movement towards de-dollarization by the BRIC countries.3
War in Ukraine, demanding resources and adding to chaotic world events.
The recent Israeli-Palestinian conflict which could potentially trigger an even larger more protracted conflict in the Middle East.
I’m no international relations expert, but these events will certainly have a significant effect on the world and U.S. markets.
Consumer Sentiment
Consumer sentiment is the largest factor I consider when I’m trying to evaluate how things may play out economically. Unfortunately (but also inherently), this is a very subjective measure. Broadly, however, confidence is in decline according to consumer confidence data.4
Anecdotally, sentiment remains pessimistic among my clients and colleagues. While this is not a scientific measure, they are a group diverse in vocation, age, location, family structure, and net-worth, so I often find that their combined experiences is a helpful predictor.
Potential Bright Spots
Some more positive analysts continue to point to the (albeit bumpy) overall trends for 2023 labor and stock market returns indicating that a recession may be avoided.
There Will Always Be a Recession or Economic Challenge On the Horizon
At the end of the day, whether we are in a recession or whether it’s coming, it is important that you are prepared for them during the lifetime of your financial plan. Recessions and down markets are natural parts of the economic cycle, and you will likely go through one every decade or more—whether due to personal circumstances or market forces.
Preparing for Economic Challenges
In a previous Substack, I talked about financial resiliency—the third of three pillars you need for a successful financial plan.
Mastering financial knowledge and having a driving purpose are not guarantees you will achieve your goals, so it’s important to also have a pillar of resilience—this prepares you to continue moving forward even when your purpose is challenged or changes, as it will throughout your life.
You may be in a moment of financial challenge; you may not. But here are some questions you should ask to determine if you are adequately building resiliency into your financial plan.
How secure is my employment?
This inquiry will drive a lot of the preparedness measures you should take during your lifetime. Things like: “How much of an emergency fund do you need?” or “How much household debt can you sustain?”
If you are employed by a federal or other government agency unlikely to implement layoffs in market downturns, employment security may not plague you when a period of economic unrest occurs.
However, if you are self-employed, working at a start-up, or some other employment that is impacted more directly by market forces, you will want to have a game-plan for the time you experience a drop in income or even complete job loss.
If our household income dropped significantly, how long can we continue to pay our bills?
Along these same lines, you need to be realistic about how long you could sustain your lifestyle if your household income suddenly dropped significantly. Maybe a layoff of one spouse, or a large bonus is forgone, or other market forces cause a decrease in income.
Addressing Reduced Household Income
The solution to the above question is to make sure you have enough cash on hand to get you through at least three months of a significant household downturn. Six months would be preferable, but three gives you time to come up with a plan for downsizing, etc. if it looks like your income will be contracted for a longer period of time.
For those of you struggling with how much you need and how to build and invest your emergency fund, check out my previous Substack and wrote some guidance and created a video.
What percentage of my income is paying on outstanding debt?
Whatever percentage of your household income is going towards debt, you should be looking to reduce it—particularly if it is consumer, auto, or other debt on depreciating assets.
Financial advice ranges from about 28%-36% for rules of thumb for a reasonable debt load for a household. This includes your mortgage.
Here is my advice: treat your mortgage debt as separate from everything else—ideally that is less than 30% of your gross household income.
You need to immediately work on repaying any other debt—every single month you spend putting money towards debt is money you no cannot use to fund your other goals.
What is my plan if the market returns are poor for 1–3 years? (Or: What if my income is subject to change due to poor investment returns?)
If you are currently working and investing, your plan should be to do nothing. Continue your current course. Make sure you focus on your short- and mid-term goals like having an adequate emergency fund and paying off unproductive debt.
If, however, you are in retirement or it is imminent, I recommend building a strategy for the long term that accounts for short term behavior during market downturns. It might look something like this:
The majority of your investments should be allocated for the long term, even in a downturn. This means you should remain in equities even when they are down.
Keep 1–2 years worth of living expenses in cash. That is the sweet spot; you can use this cash during down years to sustain your retirement expenses without selling your investments in a down market.
Here are some ways to start working towards that 1–2 year cash goal:
Have pared-down budget. Know exactly where you can reduce your lifestyle if and when there is a downturn. Things like: travel, dining out, entertainment, memberships/clubs, etc, can all be removed from your spending if needed.
Implement a pared-down budget for a period of time to save cash. If you can reduce your spending for a period of time and save some cash, now is the time.
Remember: High-interest savings accounts and money market are fairly competitive now, so you don’t have to earn nothing on these monies that you stash away.
What You Must Do Right Now (& Always)
Evaluate how prepared you are in relation to the above questions. But here are the things everyone should do or not do during all market cycles—up and down.
TO DO
Emergency Fund – Build a healthy emergency fund based on your situation.
Payoff Debt – Look to pay off all your debt, with exception of a low-interest mortgage. Once that debt is paid off, start using those debt payments to make your financial situation more resilient through increasing your retirement savings or stashing more cash.
Delay Large Purchases – If poor economic conditions are happening to you now, or seem as they might, it is time to delay any large purchases or expenses.
Keep Investing – No matter where you are in life, keep your investments invested. If you are still contributing—keep putting money into the market as if nothing is happening.
DO NOT Change Your Investment Allocation – Do not try to change your holdings based on the current market cycle—or any market cycle. Your allocation should be something that was intended to stay in place for decades. Shifting into gold or cash or some other attempt to “hedge” will not be successful. (Nobody can time when to shift out, or more importantly, when to go back into equities. Research confirms that investors who try to reallocate their investments in response to market events receive lower returns than if they had stayed the course.)
Prepare for the worst, hope for the best.
If you are a client, you have likely heard me say: “hope is not an investment philosophy.” I stand by this. Hope is great, but your job when it comes to your finances is prepare for real downturns in the market that may come now or in the future—but they are a part of the cycle and should be something you build into your plan.