Though the ride has been bumpy at times, long-term investors have reaped great rewards over the past decade. Since hitting their Great Recession lows in March 2009, the iconic Dow Jones Industrial Average, tech-heavy Nasdaq Composite, and broad-based S&P 500, have returned 319%, 563%, and 355%, respectively. Considering that the historic average annual returns of the S&P 500 and Dow are closer to 7% and 5.7%, respectively, this has been an incredibly good run for the stock market.
Unfortunately, we also know that stock market corrections are normal, and recessions are a natural part of the economic cycle. In other words, all good things must come to an end at some point. The big question is, "When?"
Image source: Getty Images.
It's not a matter of "if" but "when" the next recession will strike
In recent months, a number of recessionary red flags has surfaced that suggest an economic downturn may be around the corner.
For example, we've witnessed a number of short-term yield-curve inversions. The yield curve is a visual representation of the yields of various Treasury bonds, mapped out by maturity date. Generally speaking, we'd like to see a nice upsloping curve, whereby shorter maturity bonds have lower yields than longer-term bonds. This makes sense given the time premium bond buyers give up to hold an interest-bearing asset for say 10 or 30 years. In the case of a yield-curve inversion, short-term notes have higher yields than long-term bonds. Since World War II, every recession has been preceded by a yield-curve inversion, albeit not every yield-curve inversion has subsequently been followed by a recession.
Another clear concern can be found on the manufacturing front. Even though manufacturing isn't the dominant growth driver for the U.S. economy as it was in the 1980s, it's still a major indicator of economic health. For the past three months, the ISM Purchasing Managers Index has come in below 50%, which is indicative of a contracting manufacturing sector. In fact, the reading in September was the lowest in more than 10 years.
The rise in corporate debt is also concerning. The Federal Reserve's long-lasting dovish monetary policy has allowed businesses to borrow money very cheaply, which has driven up leverage and encouraged publicly traded companies to issue their own debt (e.g.'s secured notes and convertible bonds). When the next recession strikes, it's unclear if companies will be able to meet their debt obligations.
But perhaps the biggest warning of all comes from Warren Buffett, whose actions speak louder than words.
Berkshire Hathaway CEO Warren Buffett at his company's annual shareholder meeting. Image source: The Motley Fool.
128 billion reasons to be a worried investor right now
Buffett, one of the richest people alive, and a longtime advocate of the keep-it-simple buy-and-hold investing strategy, hasn't been doing much on the investment front in recent years – and that's disturbing.
Buffett's conglomerate, Berkshire Hathaway (BRK.B -0.01%) (BRK.A -0.34%), generates income two ways. For one, Buffett and his team have a current portfolio of 47 securities worth about $234 billion. Like any long-term investor, Buffett is out to generate big gains and substantive dividend income with his firm's investments.
However, Berkshire Hathaway has also been an avid acquirer of businesses from a host of industries and sectors throughout the years. In total, Buffett and his team have bought about five dozen businesses, and these business contribute to Berkshire's overall revenue and income.
For his part, Buffett has long felt that he'd be most comfortable with Berkshire Hathaway's cash pile around $30 billion. This assumes that the company is putting its cash to work by making acquisitions that will grow its bottom line. But something strange has happened. Since acquiring Precision Castparts about 3.5 years ago, Buffett and his team haven't made any needle moving acquisitions. In turn, Berkshire Hathaway's cash pile has grown to a record $128.2 billion, as of the end of the third quarter.
Although Buffett would never say anything overtly negative about the stock market, he doesn't have to – his actions are speaking loud and clear. By continuing to build up Berkshire's war chest, Buffett is proclaiming that there's no company in any industry that presents an attractive enough valuation to acquire. Remember, Buffett isn't necessary after a deep discount. He merely wants a "wonderful company at a fair price," and right now he can't find that, based on his lack of acquisitions for the past 3.5 years (and counting).
Image source: Getty Images.
Even if Buffett's actions signal trouble ahead, selling would be bad move
So, does this mean John and Jane Q. Investor should run for the hills?
Let's just say, for the sake of argument, that Buffett is "correct" – remember, he hasn't said the stock market is overvalued, but his actions prove otherwise – and stocks do wind up deflating at some point in the future. The thing is, we have no clue when this correction will occur, what will cause this correction, how long it'll take for the market to find bottom, or how far the market indexes will fall.
What we do know is the following:
- Stock market corrections of at least 10% happen, on average, every 1.9 years.
- Close to 60% of all corrections find their bottom in less than four months.
- Of the 37 official corrections since 1950, each and every one has been eventually erased by a bull market rally.
- The stock market has spent nearly three times as many days rallying as it has spent in a correction.
While it is perfectly fine to be concerned about Buffett's lack of buying, it's also important to realize that, over the long run, any near-term valuation concerns will seem trivial.
For example, the stock market was arguably very pricey during the dot-com boom in the early 2000s, with the S&P 500's P/E ratio jumping to more than 33. Yet, the S&P 500 has doubled since this pre-recession valuation peak nearly two decades ago.
In short, you'll miss every swing you don't take, and the more swings you get, the more likely you are to hit a home run out of the ballpark in the stock market. Buffett's $128 billion in cash is unsettling, but it shouldn't alter your buying habits.
