ETF INSIGHTS: SAHM RULE RECESSION INDICATOR WARNING – WHAT TO DO NEXT?

The Sahm Rule has accurately predicted every U.S. recession since the 1970s and has recently been back in the news as it’s flashing a warning. What exactly is the “Sahm Rule” and how might one position their portfolio if they believe in its predictive power of identifying a future recession?

The Sahm Rule is named after American economist, Claudia Rae Sahm, and was introduced in 2019 as an indicator to identify the initial phase of a recession. In short, the rule states the following:

If the three-month average of the unemployment rate has risen by at least 0.5 percentage points above its 12-month low, a recession typically follows.

Part of its popularity, in addition to the fact that it’s “time tested”, is its simplicity in connecting unemployment and a recession: Rising unemployment means lay-offs which in turn leads to less spending and a self-perpetuating cycle of negative growth. A rapid rise in unemployment would be the canary in the coal mine. With the July unemployment figures just released (Exhibit 1), the rule has now triggered a warning and has many people talking…

Source: www.fred.stlouis.org

It’s Different THIS Time (POSSIBLY)

Not everyone agrees that a recession is a foregone conclusion. In fact, even the creator of the Sahm Rule was recently quoted saying, “A recession is not inevitable and there is substantial scope to reduce interest rates.” (Source: Forexlive.com).

So why might this time be different?

Dramatic shifts in the labor force have made it different from past cycles. For example, the surge in immigration and the plunge in unemployment early in the pandemic has made the dynamics of today’s market dissimilar to previous ones.  Not only is unemployment coming off historic lows (Exhibit 2), but entrants (those either returning to the labor force or without work history) have not fallen as it has in past recessions. This would indicate that the higher unemployment rate is coming from a higher labor supply of immigrants along with those who are returning to look for work after leaving during COVID and not due to weakening demand and a sudden rash of layoffs.

(Source: www.fred.stlousfed.org)

While higher unemployment is never good, it is far worse when long-term employees are losing their jobs. Nonetheless, the triggering of the Sahm Rule does give us reason to pause and evaluate our portfolios as the possibility of a recession is still elevated.

Positioning Your Portfolio

So, what are some proactive steps you can take to position your portfolio if a recession is imminent? 

One idea that we find worth exploring is the migration from tech-heavy growth strategies to strategies focused on high quality dividend paying equities. More specifically, high quality dividend paying stocks that can grow their dividends. We believe that one fund that is worth considering is the newly launched actively managed ETF, AAM Brentview Dividend Growth ETF (BDIV). BDIV is sub-advised by Brentview Investment Management which has over 25 years of experience across various market environments, including recessions. BDIVs underlying investment strategy is the same strategy that Brentview has been managing for institutional clients since 2006.

There are several aspects to this fund that may potentially help limit downside losses if the economic situation turns from a soft to a hard landing.

Extensive Research. The first aspect to consider is the rigorous quantitative financial analysis given to dividend companies along with qualitative analysis. BDIV examines the strength of the balance sheet, the potential for future free cash flow generation, the sustainability of dividend growth, the business’s competitive advantage, as well as whether the business model itself can support consistent and future dividend growth. In a nutshell, when the economy turns down, strong companies with high-quality earnings have the potential to support dividend payments while weaker companies may freeze or cut the dividends.

Volatility Management. Large downside fluctuations in the portfolio can make it a challenge to hold the course. Dividend strategies that focus on high yield are often heavily concentrated in specific industries or sectors which can be a potential form of risk. Higher yielding stocks often carry higher volatility risk. BDIV manages this by diversifying across all sectors, dividend growth rates, yield, and beta. A range of underlying factors and properties will spread the risk out for a potentially smoother ride.

Buying Opportunity. There is an additional behavioral aspect to dividend investing which may lead to more favorable outcomes. If the market does experience downside volatility, the underlying dividend yield will increase. As the investors in these funds focus on the objective of increasing the total future income streams, they will be bothered less by temporary portfolio fluctuations in price. This is to say that cheaper prices will allow them to get more dividends for their dollar and they may be more prone to buying during a market correction – which is the right thing to do – instead of panic selling and buying back at a higher price.

Conclusion

Whether the Sahm Rule is a false positive or not, we believe solutions like the AAM Brentview Dividend Growth ETF may be worth exploring…with or without a recession.

For more information on the AAM Brentview Dividend Growth ETF (BDIV), please contact your financial professional or visit us at www.aamlive.com.

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