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How Predictable Is The Economy?

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The following is a guest post from William Cowie @ www.dropdeadmoney.com.

How did the recession of 2008-09 affect your plans to retire by 40? Or any age, for that matter? Did it set you back a bit?

Or did it move your plans forward by a few years? It should have.

(Joe> 84% of our readers are better off today than 4 years ago. That’s actually quite amazing considering how deep the recession was.)

Forward? How can a recession advance anybody’s plans to retire?

Glad you asked.

Understand Recessions Are Inevitable

They’re actually even predictable to some degree.

Take a look at this chart:

us economy cycle 1948 to 2012

Since World War 2, we’ve already had 11 recessions. And if you go back another hundred years, you’ll see the same pattern. Those dates in red show the bottom of each recession. Now look: how far they spaced apart?

Would you agree: another recession is inevitable? It’s only a matter of when. In the past, recessions occurred at intervals of 7-10 years (barring a few that came a little quicker).

It’s almost like summer hurricanes in theCaribbean. We know they’re going to happen. We just don’t know when and where exactly. Fortunately, we’ve developed a good system of hurricane warnings.

A hurricane warning is useful, because while it can’t change the course of the storm, it can predict its path with some accuracy and the warning enables people in its path to board up their houses and evacuate.

So the warning doesn’t take away the storm, but it significantly reduces the damage it causes.

And, as you can see above, we have developed enough knowledge about the economic cycle and its “bad face:” recessions.

The Cycle Has Good Faces, Too

The economic cycle is not just about recessions, just like weather forecasting is not just about hurricanes and tornadoes.

If you look at the chart above, you will see a pattern. From one bottom to the next bottom is one cycle. Although no two cycles look exactly the same, you can clearly see they each have the same pattern.

Here is where this discussion turns from merely interesting to life changing.

Why is that? Because each cycle can be broken down into four distinct phases, much like a year has four seasons.

In fact, with a single exception, each phase of a single economic cycle corresponds closely to its natural season counterpart.

Winter = recession

Spring = early recovery

Summer = “normal” growth

Autumn = harvest

Here’s a diagram showing how these phases flow from one to the other:

single economic cycle

Why is this significant? Because what you do in each “season” is sufficiently different that if you do the wrong thing, it can set you back years in your quest to retire early.

So what are these things to do and not to do?

Spring

Just as recessions are inevitable, so also is the recovery after recessions. Every recession we’ve had, and we’ve plenty, is followed by a recovery. This is the time a farmer plants. It is the ONLY time a farmer plants. Likewise, in the economy, this is the only time to invest. This is when prices are their lowest. Buy low, sell high? This is buy low time. Prices are never lower than this time.

A farmer CAN plant later in the year, but those plants will not mature and deliver a crop. In the same way you CAN invest when prices start rising, but you’re missing the main benefit.

Summer

Spring turns to summer imperceptibly but when it does, planting season is over. Then all a farmer does is work hard and tend the crop: make sure it gets water and the bugs and weeds are kept under control. Likewise in the economy, this is when things heat up and simply maintaining what you have: your job, your business, your investments, absorbs all your attention.

Fall

This is the interesting season in the natural, and it’s also the interesting “season” in the economy. This is when the economy begins to overheat and you see inflation and all kinds of shortages and “bubbles.” A bubble is when prices for some item begin to skyrocket past all logical explanations. Think housing bubble 2007 and tech stock bubble 1999. (8 years apart, by the way – do your own math for the future.)

In the natural, a farmer uses this season to cut down everything and sell it. That’s what harvest season is for. It’s what you should do in the economic harvest season as well. This is the “sell high” season in the buy low, sell high advice. Sell everything. If you have a 401k, IRA, or stocks and/or mutual funds outside of retirement funds, this is the time to sell and put the proceeds in a money market fund. No, it won’t go up, but this is the time of the economy you want to heed that other advice of Warren Buffett: don’t lose it. You know the markets are all going to fall. They always do after the bubble season is over.

Remember when we said recessions are inevitable? They’re especially inevitable (if there is such a thing) after bubble season. Here’s a historical fact: every single bubble in history was followed by a recession. Every single one. You can hold out for the last little bit of gain, or you can be cautious and cash out while watching others chase the last musical chair dollar. But when the music stops, you need to have all your assets cashed out, waiting for the inevitable drop.

If you wanted to go extreme, even sell your home. You can buy it back in a few years for a lot less. Or buy a nicer home for the same price. (I said it’s extreme, so don’t yell at me.)

Winter

No surprise: winter = recession. Nothing happens on a crop farm in the winter, and nothing happens in the economy in a recession either. Other than prices dropping like crazy, people losing their jobs, homes being foreclosed on, and so forth.

If you’re not prepared, recession can be quite a miserable time. However, if you are prepared it’s like seeing winter come, and taking a plane to Cancun orJamaicafor the winter. Yeah, it’s still winter, but because you’re prepared, winter is nice.

If you did what we said above and sold everything in the harvest season and got out of debt and ended up with cash, this is where you rub your little hands together, because this is what you’ve been waiting for: bargains!

Think back a couple of years — everything was on sale! From cars toCaribbeancruises, everything was 30% off or more.

This is the time to buy a house, whether for yourself or for an investment rental property. But you have to have money, because the banks are so gun shy in times like these, you’ll have to have at least 30% to put down, instead of the usual 20%. If you’re contemplating buying your first house, wait. Wait until this season happens. It always does, and it doesn’t take that long. But the saving is worth the wait.

If you’re into stocks or mutual funds, this is the time to load up again. You almost can’t go wrong. It’s like shooting fish in a barrel — almost every stock is undervalued.  Everyone around you will moan and whine like it’s the end of the world, but it isn’t. It’s only the next season. Time to buy, because this season is followed by spring and summer. It always is.

What Did You Do?

Did you invest when prices were high? You won’t be the only one – 25% of all mortgages in August 2012 were underwater, and that’s only because people bought their houses when prices were too high.

If you want to retire by 40, the key is to understand the flow of the economic cycle. I did, but I started too late. Even so, I practiced what I preach and I came out of this last recession in the best financial shape of my life.

So can you. The time to prepare for the next recession is now. Don’t wait until it is too late.

William Cowie was able to retire after the last recession by keying his decisions off the economic cycle. Get his free how-to at www.dropdeadmoney.com

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{ 22 comments… add one }
  • Mauro D'Andrea September 28, 2012, 1:12 am

    Hi William, this is a very interesting post!

    I knew recessions are cyclic, but I didn’t know they occur so often.
    I think that hurricane and seasons metaphors are a perfect fit.

    Thanks for sharing this information.

  • retirebyforty September 28, 2012, 1:22 am

    The problem is that most investor (including me) can’t recognize when it’s time to sell. People were calling the housing bubble years before the price finally dropped, right? If you sold your house in 2005, you would have to wait maybe 5 years before you can buy it back at the same price.

  • William @ Drop Dead Money September 28, 2012, 1:36 am

    Mauro, yes, the frequency catches many people by surprise. I know I was stunned the first time I saw how frequently, and how regularly (evenly spaced) we have recessions.

    RB40, yes I hear you. Calling the top is difficult, and that’s not really what we should seek. Even if you sold in 2005, you’d be able to buy back (in most cases) for less 5 years later. I think the magnitude and duration of this last bubble was unprecedented (that’s a whole debate by itself) and that’s why the recession was so much more severe than previous ones.

    Where I end up with this is the resiliency of the cycle. It follows its course, almost no matter which party or which individual leads the country. And that’s why I don’t expect the economy to drop into a recession this year or next.

    Lastly, I think wealth is created by buying more than selling. Therefore, I use the cycle more as a buying guide than a selling guide. In particular, buy like crazy when others are too spooked.

    Does that make sense?

  • Roshawn @ Watson Inc September 28, 2012, 5:39 am

    I personally would not be speculating or trying to use appreciation if my time frame for needing the money was short. That kind of defies a primary purpose of long-term investing, which is what I do. Thus, the economy will do what it does, but as long as I have means to earn income and build assets, then I’m not overly concerned with what the markets are doing. I care only to the extent they affect my assets.

    • William @ Drop Dead Money September 28, 2012, 7:49 am

      You’re absolutely right: this is not for a short term window. This is a long term perspective, a very long term perspective. I don’t think many people will go through more than a total of three or four economic cycles in their entire adult lives. Please note this is not the normal up and down of the stock market we are talking about – it’s the economy as a whole, and those cycles rarely last less than 7 years each.

      Because of the extremely long view, I don’t regard this as speculating. Speculating to me is buying and selling inside of a one or two year window. The approach I’m talking about looks at a 10 or year window for a single cycle. Everybody has their own criteria, but that’s long term enough for little old me.

      I wouldn’t regard a general rebalancing to go liquid once in ten years, and getting reinvested once in ten years, as speculating. Once I’m in, I stay in and ride out short term fluctuations — what Warren Buffett calls the art of doing nothing.

      The economic cycle affects the value of our assets, and affects that value greatly. So greatly that this is the one move everyone can profit from paying attention to. Anyone who bought a house in 2007, and every one of the 25% of all mortgages which are under water today, will probably agree that if they waited a couple of years to buy, their net worth would have looked a whole lot better today. And that’s really what I’m talking about.

      If someone was young enough to think about retiring by 40, I figured that gives them enough time to still go through at least two cycles.

      I only had one cycle to benefit from. I was fortunate enough to have had some cash to jump in at the low point. That made up for several decades of mistakes, so much so that it allowed me to retire, so I figured I wanted to share that with others who have dreams of retiring…

  • As soon as I saw the title it knew it was an article by William! These are great points and I am glad you are getting the word out!

  • Travis September 28, 2012, 7:13 am

    FTA: “Fall: That’s what harvest season is for. It’s what you should do in the economic harvest season as well. This is the ‘sell high’ season in the buy low, sell high advice. Sell everything.”

    That works directly against the old adage of “sell in May and go away.” Over the long term, the summer months have proven to be the worst returns. The historical returns show if you sell in May and buy again in October, you would get an average of 8.4% over the last 86 years. However, if you sold in October and bought in May, you would have only received a 5.1% return.

    Before following Williams “advice,” make sure you do your own research on how the market moves. Here’s another piece of data from the Motley Fool from April 30, 2012 (article titled: Should You Sell in May? Read This First):

    S&P 500 Returns from April 30, 1926 to March 31, 2012

    Sell in May, buy back in October: 8.4%
    Buy in May, sell in October: 5.1%
    Buy-and-hold: 10.0%

    It looks like the worst thing you can do is follow William’s advice of “sell everything” in the fall. By doing the exact opposite of William’s advice, you can get a better return over the long-term. But, the best is still the buy-and-hold investors.

    • retirebyforty September 28, 2012, 7:54 am

      I don’t think he meant literally buy in Winter and sell in Fall.

  • William @ Drop Dead Money September 28, 2012, 7:27 am

    Travis: I was not talking about Fall in the natural — sorry if that wasn’t clear. I was trying to draw a parallel between the Fall phase of the economic cycle and the natural harvest season. The last instance of an economic Fall phase would have been 2006 and 2007, when prices escalated beyond what is reasonable.

    An economic cycle lasts 7-10 years, so each phase will last longer than the 3 months of a natural season. So the harvest phase of the economic cycle will last longer than 3 months, and they will not correspond with the September-December time of year.

    Does that make sense?

  • Travis September 28, 2012, 7:56 am

    Oh wow, talk about misreading your article! I’m sorry I didn’t reread the first part before commenting. Yes, it makes sense now.

  • Steve September 28, 2012, 12:13 pm

    Sooooo… how do we reliably identify where in the cycle we are?

    • retirebyforty September 28, 2012, 12:22 pm

      I would be a billionaire if I can reliably do that. 🙂

  • krantcents September 28, 2012, 3:49 pm

    The rising real estate prices scared me off early. Although I did sell my mother’s condo into the rising prices. I managed to get the highest price possible and reinvested into a rising real estate boom in San Francisco.
    There are always cycles that you need to watch out for, but you have think long term.

  • william September 28, 2012, 4:15 pm

    You’re right. Long term is the key, meaning patience is the word – just what all of us like, right? 🙂

  • FI Fighter September 28, 2012, 7:24 pm

    Unfortunately, I also suck at timing the market, so I would have no idea when to cash out. Instead of trying to figure this timing out, I rely on dividend growth investing.

    By using this method, I am always in an accumulation mode. When the economy has a downturn and everyone is spooked, that’s the signal to load up. When the bubble is starting to form, it should be somewhat easy to identify since P/E ratios will go through the roof, and yields will drop.

    When stocks are sitting at 52 week highs, don’t buy. Unless you are buying premiere blue chip companies, which also provide a margin of safety – companies that have been around and withstood the worst of recessions to only come out stronger afterward (companies such as KO, PG, JNJ which not only didn’t cut the dividend, but actually increased them during times of panic).

    I don’t think there’s really any fool-proof way to invest where you are guaranteed to come out ahead, though dividend investing works well for someone like me who prefers to buy and not worry about timing when to sell.

  • ed September 28, 2012, 8:44 pm

    I think the problem with the nature of recession cyclicality which causes us to ponder that we’re due for one, is that the nature of what we now call the Great Recession is it has much of its staying power and sting due to the fact that it is a massive debt deleveraging event – it is not due to what characterizes most of the recessions shown in your graph which is routinely due to credit contraction caused by monetary policy of raising interest rates to reduce the ability to continue to leverage up to spur economic activity. Thus, shall another recession befall us, the normal tools to combat the cycle are not likely to have much effect at all. What then, more quantitative easing?

    • William @ Drop Dead Money September 29, 2012, 8:13 pm

      Very perceptive! The deleveraging move is overdue and necessary. But it comes at the cost of growth. Pick your poison…

  • Wayne @ Young Family Finance September 29, 2012, 7:13 pm

    This seasonal description of economy was the most interesting and sensible description I have ever heard of the economic cycle. I used it to explain the principle to my wife, who is notoriously bored by anything related to economics – and she agreed. What season do you think we are in right now?

  • William @ Drop Dead Money September 29, 2012, 8:04 pm

    Thanks for the kind words, Wayne. I offer a (free) update every quarter to those on my mailing list, because let’s face it, the economy moves very slowly and it’s easy to lose track of it amidst the hubbub of daily life.

    Which is code for: I can tell you now, but what are you going to do next March? 🙂

    All of that shameless plugging aside, I’d say we’re in early summer. But it’s an unseasonably cool summer. There is growth many places, but every now and then you see some spooking report. The Fed is determined to run the gigantic heater till the weather warms up on its own. Will it work? Or will it fuel a bout of inflation? (http://bit.ly/PTinflation) Will the infamous fiscal cliff materialize, and if so in what form?

    We’re dealing with so many “first time evers” I don’t think anybody knows exactly what”s going to happen.

    So far, though, the cycle seems to have a life of its own. If that remains so, something will catch fire and pull the economy with it.

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