As our current phase of the economic cycle continues and the S&P 500 touches new highs, it is easy to have mixed feelings about what comes next. At 98 months, the current economic expansion is the third longest in modern history and is over twice as long as the average expansion of 47 months. However, with subdued expectations of tax reform, there is also room for an upside surprise if Congress can get their act together. So how do we go forward?
It is easy to say that a downturn is coming but far less straightforward on how to predict when that will actually come. Much like saying we are due for rain after a long dry period, the logic is sound but mostly useless in making a decision. It is important to remember that while mean reversion can be helpful in the long-term, it has a poor track record for making short-term timing decisions.
Another factor to consider is that returns leading up to a recession tend to be fairly robust on average. Two years before a recession returns average 21 percent and even the year before returns average 8 percent. Unfortunately, these are only easy to see in hindsight and not beforehand. Missing out on these returns in some ways can be riskier than waiting it out in the markets.
So what is the best course of action? While the answer is boring, staying appropriately diversified is still the best way to counter uncertainty. Developing the appropriate asset allocation for your specific situation can give you confidence while the future is unknown. There are most likely still some returns left out there before the next recession and exiting the market has proven to be one of the riskiest and least successful moves an investor can make. With a balance of defensive assets such as bonds, we can reduce our exposure to the volatility of a stock market pullback but we should make sure that we never stop marching forward towards our long-term goals.