Video Update: How the Upcoming Recession Could Be Worse Than Expected

Key economic indicators and Fed leaders continue to forecast a recession this year.

While we predict – and all signs show – it’ll be a mild one, there are certain factors that can impact how long this upcoming recession could go on.

In today’s video update, Chief Analyst Adam Galas lays out what those factors are… how long this recession could last… and what it’ll mean for your portfolio.

As he’ll explain, at Fortress, our strategy gives you the highest likelihood of getting through market turbulence and economic uncertainty – no matter how long it lasts.

Click below to watch the video.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome Fortress Portfolio members to another weekly video update.

Today we're talking about what could cause the recession to be worse than expected.

Now, last week we talked about why a mild recession is likely coming soon and the latest economic data coming in points to July as the most likely start date. The bond market is currently agreeing with the most inverted yield curve in history.

Now, according to studies from the New York, Chicago, Dallas and San Francisco Fed, the yield curve (the difference between various duration bonds such as the three month and ten-year Treasuries) is the most accurate recession forecasting tool in history.

In fact, for the three month and ten-year curve, it has a perfect record prediction for the last 50 years.

The yield curve inverted in October and based on past history, this means there is a 100% chance of recession by October of 2024.

Now the Fed's minutes show that in the last meeting they actually discussed whether or not a recession was coming.

Because of the banking crisis, the Fed actually believes a mild recession is likely to start this year.

And they still plan to still hike 25 more basis points.

Now, the next Fed meeting is 15 days away.

And there's only one more important economic report coming out by then… The Personal Consumption Expenditures price index (PCE) inflation report, the Fed's official inflation metric.

Now, the good news is that the banking crisis the Fed was worried about has calmed down a bit.

We've seen the emergency borrowing from the Fed by banks decrease for four straight weeks.

Financial stress, as we talked about last week with the St Louis Financial Stress Indicator, is back to average levels since 1993.

And last week, $63 billion in deposits went back into regional banks.

However, we're still likely to get that recession and there is a chance that it might be worse than currently expected.

Why is that?

To answer that, let's consider the Fed and the government playbook. The is different than every other recession over the last 40 years.

In a normal recession such as 2011, the government spends money, cuts taxes, and the Fed cuts interest rates.

And in a severe recession, like the Great Recession or the pandemic, the Fed also prints money to buy bonds to lower long term interest rates and flood the economy with cash.

Now, remember that 9/11, was the mildest recession in history.

And today, we have that fiscal stimulus…

This time, though, the Fed cutting rates is not likely to happen.

How do we know? Because of various Fed speakers, for example, Governor Waller, just came out yesterday and said, nope, no cuts. We still have more work to do.

President Bostic, the president of the Boston Fed, came out a few days before that and said the same thing.

In fact, three Fed speakers since the March rate hike have all came out and pretty much said the same thing.

Inflation's not beaten yet. The Fed's not done hiking, and when it is, it's not going to cut this year.

Remember, the Fed is expecting a mild recession.

In other words, just because you're in recession doesn't mean the Fed has to cut. Not when inflation is still this high.

In fact, the Fed thought plot shows that they might not cut until as late as September of 2024. Now, the good news is this recession is likely to be about six months longer. Currently, that's the expectation with a 0.6% peak decline in GDP and still positive point 9% growth for the full year.

In other words, the mildest recession in history.

That's courtesy as of (as we talked about last week) the $4 trillion in excess consumer savings, $3 trillion in corporate cash and record surpluses for states and cities.

However, if the Fed isn't cutting and if the government's not stimulating – and we can see that because of the congressional gridlock there is not going to be any stimulus – the economy is going to have to stand on its own.

Now, this means potentially the recession might last a bit longer, nine months or even 12 months… And it might be deeper than that 0.6% contraction economists currently expect.

In fact, historically, economists always underestimate how bad recessions are going to be.

So does that mean it's time to hide in a bunker, sell everything, go to cash, even short the market? Is it time to bet big that stocks are going to crash?

The answer to all these questions is an emphatic: Hell No.

Remember, the average recession since World War Two is not a catastrophe. It's a 1.4% contraction in 2020.

Even with the pandemic, it was a 2.8% contraction, twice as bad as the historical average.

In the Great Recession, it was a 4.6% contraction, three times the average downturn.

So even without federal or government stimulus, the bearish case for the economy is that this is going to be a garden variety average recession.

And remember, that's the bear case. The most likely case is a mild recession.

But even if it's worse than expected, it's probably going to be a 1.4% contraction or something close to it. And what does that mean for earnings?

About 13% is the historic recessionary contraction in earnings. Now, that's the good news.

But there is some bad news for the stock market thanks to this hope-inspired rally of the last few months.

Stocks are now highly overvalued.

For example, we just saw how 13% is the average earnings contraction in a recession. Now, the average trough price-to-earnings ratio in a bear market is about 14.

Puting those numbers together… It means the S&P historically could be expected to bottom at about 2800.

Well, that's a 33% decline from here, and that would be a 43% peak decline.

Now, that kind of market crash you normally only see every 50 years on average. But as one of my favorite investors, Howard Marks likes to say a six-foot man can drown in a river that's five feet deep.

On average, we if we did see a 43% decline, that would be the third such crash in 25 years.

Now, there is some good news and that's that with inflation, earnings this high tend to hold up better than your average recessionary bear market.

That's why the current consensus is that earnings this year will be flat or maybe fall 5%, not 13%, and certainly not the kind of 20% declines you see in the most severe recessions.

Now, if the recession is longer than expected, there's also some good news there because remember, the stock market always looks ahead 12 months.

So had this recession started in late 2022, then we'd be looking at 2023 earnings.

But if it starts at the end of this year, as it appears to be likely and lasts longer than expected… This basically means that the market is likely to bottom around 3300, which happens to be the blue-chip economists consensus.

Now, that's the good news.

The bad news is, that’s still a 15 to 30% likely decline in the next few months.

Now, that would mean a 31 to 37% historically average bear market.

And, as we talked about last week, there is nothing average about bear markets, at least not to the people living through them. They always feel terrifying, like the end of the world.

But it's important to remember why these historical averages, and the context that they give us, is valuable.

Because while every recession and bear market are caused by different things, the fundamentals that define what companies are worth, never change.

Blue chip companies like the S&P can only get so cheap. That's why if we consider the example of the pandemic, this is true in the most extreme situations.

Remember, in the pandemic, we had an unprecedented global lockdown.

GDP fell 8% in a single quarter. On an annualized rate, it was -30%. That’s three times worse than during the Great Depression.

It was the worst economic crash in history. We lost 20 months, and 20 million jobs in a single month.

And the St Louis Fed was warning that unemployment could go to 50%, twice what it peaked at in the Great Depression.

Throughout all this craziness, we had the fastest bear market in history, 34% in a single month. But that's still a historically average recessionary bear market.

Even with the worst economic shock in U.S. history… Why?

Because blue chip companies can only get so cheap. And remember, if the shit really hits the fan, the Fed will step in to prevent a true financial catastrophe.

That's what they did in March of 2020 when they announced $4 trillion in bond buying and triggered the strongest bull market recovery off a bear market in U.S. history. (That was 2021).

So what does this mean for your Fortress Portfolio? Well, even if we get a worst recession and expected, remember, it's like the big garden variety average, about 1.4% contraction and around maybe 9 to 12 months in length.

Now, here's the great news. As a Fortress Portfolio member, you don't have to lose a wink of sleep over this. That's because the companies that we own are built to not just survive, but thrive.

And not just through not just a mild recession, but even another financial crisis. The kind of scenario we'll talk about next week.

For example, Main Street Capital (MAIN) is one of the companies we own, and it's a BDC… And, has the highest credit rating in the BDC industry.

Main Street Capital is also the only BDC that never cut its dividend in a recession.

And given that it IPO'd in 2007, right before the great financial crisis, that's a pretty spectacular track record.

Next, let's look at Allianz (ALIZY). Rating agencies consider it the safest and best run insurance company on Earth.

This is a company with dividend dependability. It hasn't missed a dividend payment since 1890. Yes, this is a German company that's been paying U.S. investors every single year, including through WWI and WWII when we were at war with Germany.

It also kept paying uninterrupted dividends during the Spanish flu pandemic of 1918, when 5% of humanity was killed by the flu.

Now, remember, this is an insurance company. They pay out life insurance claims, and there were a ton of them in 1918. Yet it kept right on paying those dividends.

Finally, let's consider Toronto-Dominion (TD), our favorite bank.

TD hasn't missed a dividend payment since nine 1857. An incredible 166 years.

The only time Toronto-Dominion has ever cut its dividend was during WWII, when Canadian banks were asked to do so by the Canadian government as part of the war effort.

And of course, that's just the stock portion of our portfolio.

Don't forget, we have a hedging allocation of 33%. Now, why 33%?

Because over the last 50 years, including the stagflation hell of the 1970s and three 50+% market crashes, this has been the optimal hedging allocation for a long term recession.

This is an optimized portfolio, according to Nick Maggie, Chief data scientist for RADIUS Wealth Management.

And most hedges, of course, utilize assets such as bonds.

Well, we're not just using any old bonds. We're using super bonds… The longest duration 30-year U.S. treasuries, which, according to a study from Duke University, are the best long term recession hedge in history.

But we didn't stop there. We also went with the best inflation hedge in history managed futures, which happened to be the second-best recessionary bear market hedge in history.

In fact, when you combine super bonds with managed futures, the average bear market return is a gain of 25%, which is the mirror image of the average bear market for the S&P of 25%.

So what happens when 33% of your portfolio goes up 25%?

When the market drops 25%, you basically suffer half the decline of the S&P, which is exactly what our portfolio was built for… And is exactly what it delivered in 2022, and every recession since 2007.

Now, what does any of this have to do with dividend safety?

Well, volatility has nothing to do with dividend safety.

But in terms of sleeping well at night, there's nothing quite like riding over extreme market potholes in a limousine… Like we can do with Fortress.

Remember, we have a 6.7% yield that helps us sleep well at night. Your Fortress Portfolio pays you well to ride out this bear market.

And if you can reinvest those dividends, you're doing so at the best valuations in years or even decades.

That is the essence of Fortress. It is a bunker… An ultra sleep well at night, buy and hold portfolio that you can trust even if the wheels completely come off the economic bus.

Now, what if China invades Taiwan? What if this causes a chip crisis and sends inflation soaring again? What if the Fed has to hike 6% or even 7%?

What if this causes a severe recession and 20 to 25% of small U.S. zombie companies end up going bust?

Your Fortress Portfolio was designed to handle all of it.

Not because we're fortunetellers. I didn't predict the Russian invasion. I can't tell you if or when China is going to attack Taiwan.

I can't tell you the Fed is going to go crazy and tank the economy like Paul Volker did.

We can't predict elections. We don't predict individual earnings season. But none of that actually matters… Because historically, just three things determine stock returns: your starting yield, your growth, and your valuation.

And according to a study from Fidelity, 97% of investing success comes down to six things.

What are your goals? Art Is your asset allocation, right to meet those goals?

Is your risk management appropriate so you can sleep well at night and late? Let your portfolio work for you.

And finally, is your yield growth and valuation prudent and likely to achieve your targeted and necessary returns?

Look, I watch Bloomberg so you don't have to. I love knowing what's going on in the world. And, I love knowing what the latest Fed speaker says.

But this is no different than someone who obsessively watches C-SPAN or CNN.

The world isn't actually going to turn on a dime based on what some politician or Fed speaker says.

The market probably won't even react, and if it does, it's not going to react very much or for very long.

But if you focus on the time-tested fundamentals that the greatest investors in history have used to become billionaires, then you never have to pray for luck in the stock market.

At Fortress, we teach you to make your own luck so that you can retire in safety and splendor.

Thank you for joining us this week.

And a reminder to please send us your questions and feedback so I can respond to them in these videos and in our monthly issues.

Just please remember, I can't provide individual investment advice.

I hope you join us next week when we talk about the potential severe recession scenarios.

And while the stock market might have to worry about that, you as a Fortress Portfolio member never have to.

Have a wonderful week and safe investing.

This is Adam Galas signing off.