Understanding Market Turbulence: Navigating Through Recession Risks

As of this writing, the S&P 500 has declined by over 20% from its recent highs set on February 19th. In contrast, the U.S. Aggregate Bond Market (AGG) has risen approximately 1.9%, reflecting a noticeable shift toward safer assets. In this piece, we aim to share a straightforward view of why this is happening and how we intend to navigate the unfolding landscape.

Uncertainty Drives Equity Market Declines

At its core, the value of any business is derived from the expectation of future profits. These expected profits are discounted back to the present to determine the business’s current value. For instance, a lemonade stand in a stable neighborhood with consistent foot traffic holds predictable value. However, if that neighborhood starts experiencing higher unemployment, rising property taxes, or suffers a flood or fire, the value of that lemonade stand would drop accordingly. The greater the disruption, the steeper the decline in value.

Trade Wars: A Key Source of Uncertainty

The recent and proposed tariffs introduced by the Trump administration have injected uncertainty into the global economy. Most U.S. companies depend, directly or indirectly, on international supply chains—whether through importing raw materials, components, or exporting goods. Even companies with seemingly domestic operations are not immune, as an economic downturn triggered by global trade disruption affects all sectors.

President Trump’s new tariff policies have clearly triggered the current market correction. A baseline 10% tariff was introduced on all imports into the U.S., with additional reciprocal tariffs targeted at around 60 countries deemed to have unfair trade barriers. These barriers extend beyond tariffs and include export restrictions, quotas, and manipulation tactics.

According to Yale’s Budget Lab, the April 2nd tariffs and previous actions have significantly reshaped the U.S. trade landscape:

• China faces a 54% effective tariff (including previous and reciprocal tariffs), or 76% when including earlier measures from Trump’s first term.
• Japan, South Korea, and India will see tariffs of 25%.
• European goods will be hit with 20% tariffs, and vehicles up to 25%.
• The average U.S. tariff rate is now 22.5%, the highest since 1909.
• These tariffs are expected to raise price levels by 2.3% in 2025.
• U.S. real GDP growth is projected to decline by 0.9% in 2025 due to the 2024 tariffs, with a long-term reduction in growth of around 0.6% annually.

Macroeconomic Outlook: Volatility and Its Drivers

As uncertainty increases, so too does volatility. Market swings—both upward and downward—are driven by news surrounding tariffs and trade negotiations. A softening or pause in enforcement could trigger significant rallies, while retaliation or escalations would likely lead to further selloffs. Investors are effectively reacting to the ever-changing level of uncertainty.

From an optimistic (bullish) standpoint, one could argue that Trump’s tactics are aimed at forcing global alignment, particularly targeting China’s longstanding circumvention of fair trade practices. The strategy may involve creating broad pressure so that countries must choose between aligning with the U.S. or continuing trade with China under stricter conditions. If successful, this could lead to more predictable, fair global trade and stronger alliances.

On the other hand, the pessimistic (bearish) view sees a path toward U.S. isolationism. In this scenario, China and other nations form new economic coalitions, potentially reshaping the global financial order, even introducing an alternative world reserve currency. These geopolitical shifts pose serious long-term risks to the U.S. economy, especially if key trade partners turn away.

Our base-case scenario suggests that some allies will side favorably with the U.S., which will be celebrated politically and economically. However, it’s unlikely that China will fully cooperate. Instead, China may retaliate strategically, betting on America’s democratic cycles, market sensitivity, or congressional intervention to ease trade tensions. China has historically been more willing to endure short-term pain than the U.S., especially in a state-driven economy.

Market Valuation and Earnings Forecast

Regardless of the geopolitical outcome, in the short term, markets are likely to face lower earnings growth due to heightened uncertainty. This suppresses valuations as investors adjust their expectations for future profits.

With earnings projections for the S&P 500 falling below $268—and some estimates closer to $230—continued volatility seems likely. We mentioned going into the year that equities appeared stretched. Having a 10-20% decline in the equity market is a fairly normal occurrence albeit the circumstances that helped speed this decline up are more generational in frequency. If the uncertainty brings in a recession we would have a base case of 20-30% declines as realistic. While anything is possible we see historical norms generally leading us into this style of pullback.

Managing Market Declines

It’s important to emphasize that this is not a fear-driven prediction, but rather a strategic planning framework designed to help us identify opportunities. We consistently operate with the assumption that equity markets may decline to levels that present attractive entry points. Having experienced such periods before, we’ve proactively structured client portfolios based on risk categories and asset correlations before any decline occurs.

Maintaining a long-term perspective is essential to achieving success.

Let’s be clear—our objective is not to time the market. Yes, we do occasionally raise cash by selling shares with the intent to reinvest, but we are not attempting to call the bottom. Accurately predicting what stocks will do next week, month, or year is unrealistic. While we certainly have informed insights, they are not market predictions upon which we base our plans.

When we begin to deploy cash reserves we’ve accumulated, it’s not because we believe we’ve found a market bottom. Instead, our focus is on identifying situations where a quality business is trading below its intrinsic value. Broader market declines often expand the pool of companies that meet our criteria for investment. However, we are not traders looking for short-term bounces. We aim to be long-term owners of exceptional businesses.

During periods of heightened risk, our long-term approach typically involves the following strategies:

1. Review Risk Points
   We stress-test our holdings by modeling potential outcomes under various scenarios. This involves reassessing long-term return assumptions, evaluating how companies might be valued under different earnings growth rates and market multiples.
2. Remain Patient
   When markets decline, we remain patient and allow opportunities to present themselves. We don’t rush to rotate or deploy capital, and we certainly don’t attempt to trade or time markets. Great opportunities—like those seen after the 2000–2001 tech bubble or the 2008 financial crisis—often remained available 6, 12, even 18 months later. Because we focus on individual stocks, we can afford to be highly selective and deliberate in our actions.
3. Rotate for Opportunity
   As market volatility causes valuations to diverge, we may sell partial or full positions in companies that have held up better, using the proceeds to purchase shares in businesses that have declined more significantly and now offer stronger return potential.
4. Deploy Cash Strategically
   We maintain appropriate levels of cash, bonds, and lower-risk assets aligned with your risk profile. Aggressive accounts may hold only modest cash reserves from profit-taking, while moderate and conservative portfolios tend to have larger allocations to bonds or money markets. We plan to deploy this cash gradually during market declines as opportunities arise—always within the framework of your customized risk plan. Our typical approach is to add incrementally—perhaps a percentage at a time. Occasionally, a standout opportunity may justify a larger move. These “big swing” moments generally occur once a decade or so, and we only act on them when they fit comfortably within your risk parameters.

What Could Change – Things We are Watching?

A few key developments could significantly shift expectations:

1. Rapid Trade Agreements – If trade negotiations accelerate and compromises are reached, confidence and valuations could rebound quickly.
2. Policy Pauses – A temporary halt to tariff implementation would offer markets breathing room and might spark a relief rally.
3. Federal Reserve Intervention – The Fed is unlikely to act preemptively, as it tends to wait for tangible threats to its dual mandate of price stability and employment. However, if inflation eases or unemployment rises, the Fed may step in. Credit market stress, similar to 2018 or 2022, could also force its hand.

We’re closely monitoring all of these developments and are prepared to deploy the cash reserves we’ve built through earlier profit-taking. We also recognize that many stocks overreact during downturns, creating opportunities to selectively buy quality names at discounts.

Final Thoughts: The High-Stakes Game and Understanding Real Risk

We’re currently witnessing what could be described as a high-stakes geopolitical chess match between the world’s two largest economic powers—the United States and China. While some policymakers may feel the global system needs restructuring, there’s no denying the very real and present risks involved in this process.

Please rest assured—we are monitoring these developments closely and managing portfolios with patience and discipline. We remain confident in the long-term power of free markets, stable currency, the strength of our democratic institutions, and the ingenuity of human capital. Although no one can predict exactly how this will unfold, we firmly believe that investment cash flows will persist for decades. Our mission is to identify and capture strong long-term cash flows that support your financial goals.

Throughout this period of volatility, we remain focused on identifying real risks—those that genuinely threaten long-term purchasing power—while deliberately ignoring the noise and fear-driven fake risks. Ideally, this approach enables us to take advantage of mispriced opportunities created by others acting on emotion rather than fundamentals. With this said, time for me to get back to research!

To bring this all into focus, let me end with a timeless excerpt from Warren Buffett’s 1993 annual letter to Berkshire Hathaway shareholders—a brilliant distinction between real and perceived risk:

“For owners of a business—and that’s the way we think of shareholders—the academics’ definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped sharply compared to the market—such as The Washington Post when we bought it in 1973—becomes ‘riskier’ at the lower price than it was at the higher price. Would that description have made sense to someone offered the entire company at a vastly reduced price?

In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There, he introduced ‘Mr. Market,’ an obliging fellow who appears every day to buy from or sell to you. The more manic-depressive he is, the better the opportunities. Irrationally low prices periodically attach to solid businesses, and the ability to exploit such pricing isn’t a risk—it’s a gift.

A beta purist may avoid examining a company’s products, competitors, or debt, preferring to focus solely on stock price history. In contrast, we’d gladly ignore price charts if we could better understand the underlying business. After buying a stock, we wouldn’t mind if markets closed for a year or two—we don’t need a daily quote on our full stake in See’s or H.H. Brown. Why should we need one on a 7% stake in Coca-Cola?

In our view, the real risk an investor must assess is whether the total, after-tax proceeds from an investment—including sale proceeds—will, over time, maintain or exceed the investor’s purchasing power, plus a modest return. While not precise, this assessment can be reasonably estimated by considering:

1. The predictability of the business’s long-term economics;
2. The reliability and capability of management to realize its potential;
3. Management’s commitment to rewarding shareholders rather than itself;
4. The purchase price; and
5. The likely impacts of taxation and inflation on real returns.”