Recession…
It’s a word we all fear.
But it doesn’t have to be.
You just need to understand how recessions work.
In fact, you can profit from them.
Yes, economic downturns have an impact. It can mean job loss, for example… maybe for you or a family member.
The worrisome part is that it is nearly impossible to predict when a recession will strike, so all we can do is evaluate the probability of a recession in the near future.
To that end, we’ve been reviewing the four major reasons recessions occur.
In Part 1 of this series, I explained two recession triggers—tighter monetary policy and tighter fiscal policy.
Today, let’s look at the third reason recessions happen and see how much risk this trigger poses to the ongoing decade-long bull market.
Recession Reason #3—Asset Bubbles
Asset bubbles have become so common in modern history that some even look at them positively… as an easy way to get rich quick. We all have a friend who likes to brag about how they were one of the earliest investors in Bitcoin and made big bank as a result.
However, asset bubbles aren’t really such positive events.
In reality, most people lose money investing in them.
When these bubbles build momentum, with many investors and institutions buying the popular asset, they pose systemic risk. With so much of the economy invested, the effects when the bubble finally pops are big and broad. The whole economy is dragged down, resulting in a recession.
This happened at the end of bull markets in 1961, 2000, and 2007.
The Dot-com bubble serves as a perfect example of investors getting caught up in a buy-at-any-price mania.
The buying frenzy pushed stocks to unsustainable valuations. Companies were raising millions of dollars through IPOs, then going bankrupt shortly thereafter when it turned out their business models were unproven and unstable.
The same situation played out in 2007. This time, it was the housing bubble that triggered a recession.
Verdict: In the aftermath of the most recent financial crisis, central banks around the world adopted zero or near-zero interest rate policies, inflating stock and real estate prices.
Some are calling this The Everything Bubble.
Certainly, current valuations are high, but I wouldn’t call them extreme. So I don’t see this situation leading to recession at this point.
I do, however, see another by-product of near-zero interest rates as a threat—corporate debt.
Because yields on traditional investments, such as government or high-grade corporate bonds, have been so low for the last decade, investors have been opting for riskier high-yield bonds.
The latest estimates show that there is more than $5.5 trillion of corporate debt of low or marginal quality in the United States alone.
This means that, as soon as the economy weakens to a certain point, we’re going to see a series of defaults from these companies, making their bonds worthless.
You can read more about this problem here.
The point is, there’s never been been so much money invested in corporate debt. The resulting risk is systemic. When the next crisis hits, this will certainly exacerbate the situation and deepen the crisis.
However, corporate debt alone isn’t enough to trigger a crisis at this moment.
But another risk lurks, as well, that could.
I’m talking about the fourth and final reason recessions happen… and I’ll tell you all about it in Part 3 of this special series.
Stay tuned,
Leon Wilfan
