Are we in a recession?

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Welcome back to First Principles, my series with an alternate definition of FIRE — Financial Psychology, Investing, Real Estate and Entrepreneurship.

Today we’ll dive right in with the question on everyone’s mind: is a recession looming?

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Are we in a recession?

Short answer: Possibly. I may even go as far as to say “probably.”

A recession is defined as two consecutive quarters of negative economic growth, as measured by GDP. (Notice that recessions reflect the state of the economy, not the stock market. We’ll come back to that in a moment.)

By definition, a recession is only visible in hindsight, after two negative-growth quarters have passed. This means it’s possible we’re already in a recession. It’s also possible that one may be looming.

Why now?

What’s behind this (potential) recession? In a word: inflation.

As I’m sure you know, the Federal Reserve has been raising interest rates. (There have already been 5 rate hikes so far in 2022!)

The Fed is tasked with a “dual mandate” to control both inflation and the risk of recession; this “dual mandate” exists because controlling inflation necessarily carries a recessionary risk.

But why?

To control inflation, the Fed must make money more expensive to access. When borrowing becomes more expensive, people and companies do less of it, which slows spending and growth. This could lead to a couple of consecutive negative-growth quarters, which is, by definition, a recession.

What does this mean for you?

Recessions vary along three dimensions:

(1) severity

(2) duration

(3) frequency

It’s tempting to think that a recession will impact us in the same ways as the Great Recession of 2008.

This is due to a few cognitive biases, including:

Recency bias — our tendency to overestimate that an event that occurred recently will re-occur again, or to assign greater importance to things that have happened most recently.

Salience bias — our tendency to focus on events and facts that are remarkable (the headline-grabbers), rather than events and facts that are mundane.

Availability bias — our tendency to think that examples that most easily come to mind are more important or significant than they actually are.

The Great Recession of 2008 was (1) recent; (2) remarkable; and (3) easy to recall.

Its remarkability and ease-of-recall stems from the fact that the Great Recession was both high-severity AND long-duration. It felt personal; millions lost their jobs and homes, which meant that this recession impacted us in the most visceral, tangible ways possible.

For all those reasons, it’s easy to assume that every recession will look, feel and behave similarly to the Great Recession.

But will it?

Let’s turn our attention to 2022, and look at the many factors that are different this time around, including:

(1) Unemployment is at a record low. Despite the occasional warning headline (e.g. Tesla will be reducing its salaried headcount by 10 percent), the unemployment rate remains 3.6 percent as of May 2022, according to the U.S. Bureau of Labor Statistics.

(2) Housing prices continue to rise, despite higher interest rates, due to imbalances in supply-demand fundamentals. The cost of materials (such as lumber) remains high, which increases construction costs and therefore home values.

(3) Consumer spending remains strong, particularly in discretionary areas such as travel and dining. Despite higher fuel prices, airlines are seeing strong demand for flights.

What does this mean?

We may or may not already be in a recession, or enter one in the near future.

But if we do, there’s a chance this might be experienced as an “on-paper” recession, in which the daily lives of the average middle-class worker isn’t strongly affected.

If unemployment remains low, consumer spending stays strong, and inflation gets roped into check, there’s a chance that this recession will be forgotten. It might be long-duration, but low-severity.

Of course, this is one of a range of possibilities, and as you know, I’m not in the business of prognostication.

But it’s worth making the point that we shouldn’t let our cognitive biases lead us astray. Don’t assume that the next recession will resemble the conditions of 2008.

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Recessions reflect the economy, not the stock market.

Let’s return to the definition of a recession: two consecutive quarters of negative economic growth, as measured by GDP. This definition doesn’t directly relate to stock prices.

But investors react in varied ways.

There are two popular styles of investing: growth and value.

Growth investors tend to sell (or not buy) during recessions. When companies expect lower profits, growth investors are usually unwilling to pay a high price for a share of that company, so stocks can fall.

But this is counterbalanced by value investors who pick up shares of the ‘winners,’ the companies and stocks that they believe have been maligned by the market and that will emerge strong during the recovery.

Hence, the volatility.

So let’s zoom out and look at what’s happening now:

Everything (except real estate) is falling.

Stocks are volatile. Crypto is depressed. Bonds are unattractive.

And that’s not surprising, given the liquidity patterns of the past two years.

At the start of the pandemic, $10 trillion in liquidity got pumped into the monetary system. Investors used that liquidity to buy all types of assets — stocks, bonds, crypto, housing — triggering a massive spike in the value of all asset classes across the board. (It’s no surprise that “meme stocks” like GameStop and AMC Theaters became a thing at the exact moment when millions received “stimmy” checks.)

Two years ago, people were already asking the question, “what should I invest in when everything is expensive?”

Last year, that question only became louder and more pronounced.

It’s reasonable that today, as liquidity is getting removed from the system and capital becomes harder to access, the values of these assets will gyrate for awhile, then stabilize at a “new normal,” with valuations that reflect market fundamentals such as earnings and expectations.

What does that mean for you?

Expect that the rest of 2022, perhaps 2023, could be volatile. Stocks, crypto and bonds may swing for awhile as investors try to figure out the “new normal.”

But these types of events are how the market cleans itself.

The poorly-run companies run out of money and fold. Better companies take their place. And the broad market, over the long-term, reflects the growth of the winners.

Many fantastic companies started during the Great Recession; many new companies will be created during the next one.

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We created a massive, multi-day email series to deep-dive into recession and inflation in 2022 — and specifically, to talk about how it could impact the housing market.

It’s waaayyyy too detailed to summarize into this post, so I’d suggest signing up to get this multi-day email series.

If you’re even thinking about buying real estate, either as an investor or as an owner-occupant, you’ll find a ton of value in this free email series.

Get the free email series

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One of the most interesting stats to watch in coming months relates to the unemployment rate.

Right now, many entrepreneurs are struggling to hire talent. The labor market is tight. Small businesses are having a tough time competing with the salary and benefits packages offered by major corporations.

Many real estate investors (which is a specific subset of entrepreneurship) have spent years lamenting how hard it is to hire contractors — because many contractors are booked, busy, and in high demand.

Given the record-low unemployment, that’s not surprising.

If the labor market loosens, it might become easier to hire. And that will be a blessing for small business owners and real estate investors who are trying to find top talent, especially 1099 contractor talent.

Again, this is why many great companies tend to be launched during recessions:

One of the best times to create a business is when skilled talent is looking for work.

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Hope you enjoyed this issue of First Principles.

I’ll see you in the next issue. Until then!

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See you soon!