March 2023: How to manage the risk of a recession with inverse ETFs

A recession is imminent.

In my 2023 Outlook I predicted a recession in the second half of this year. And recently “smaller shops”, like Goldman Sachs, updated their predictions to match mine.

I made this prediction based on two variables: investment share and real interest rate.

Investment share is the ratio of investment to output. You can see in the chart below that when the investment share (in red) drops, output (in blue) drops one year later.

The intuition for this is that if you eat all the corn without saving some for seed, then next year you will have less corn. A portion of the output must be saved and invested in order to grow output in the future.

Points 1 and 2 on the red line show the drop in the share of investment in Q1 and Q2 of 2021. And the same point numbers on the blue line show the resulting negative output growth that occurred in Q1 and Q2 of 2022.

Points 3 and 4 show a drop in the share of investment in Q2 and Q3 of 2022. Applying the same lag I expect to see negative output growth in Q2 and Q3 of 2023.

The second variable is real-interest rate. You can see in the chart below that this rate has been rising since mid 2022. In the first half of 2022 the rate was negative due to low nominal rate and high inflation. That is because the real interest rate equals nominal rate less inflation (real = nominal - inflation).

So far the increase in the real-rate was a result of increases in the nominal rate by the Fed.

But what I argue is that if the Fed stops increasing the nominal rate, it is because there are signs of inflation decline.

And a decline in inflation increases the real-rate. That is unless the Fed reduces the nominal rate.

That is why I expect the real-rate to continue increasing into the slow down.

What is your financial exposure to a recession?

What if home prices, stocks, and bonds are all cut in half?

Many advisers are calling for a “rotation to value”. What they mean is that people should sell growth stocks and buy “safer” stocks.

The problem with this idea is that when the SHTF, everything goes down. The good and the bad.

But the good news is that it gives us an idea of what to do: prepare for an “everything goes down” scenario.

There are a few ways to profit from a meltdown. Shorting stocks or index funds, buying put options, and finally, buying inverse index funds.

Although I like using put options, I’m going to focus on the third way because it is the simplest. Inverse index funds are designed to go up when the index goes down.

In the chart below you can see the inverse fund SQQQ over time. As you can see it is an awful long term proposition. But in SHTF episodes it jumps and can shield against losses in other assets.

I found a list of such inverse index funds with descriptions and details if you wish to explore this idea further.

Good luck!