Equity Markets During Recessions
January 4, 2023
The final months of 2022 brought some encouraging economic data. After the Federal Reserve rapidly increased short-term interest rates, the pace of inflation slowed over the second half of the year. In addition, the labor market still appears to be strong entering 2023. Even so, according to Bloomberg, the median estimated probability of a recession in the next 12 months is 65 percent. Though this suggests that a recession is only slightly more likely than a continued expansion, it is up from 15 percent a year ago. Given this growing pessimism, it’s a good time for investors to review the history of recessions in the US and how US equity markets have performed during those recessions.
There have been 34 recessions in the US since 1854, lasting 17 months on average. The longest recorded recession lasted nearly five and a half years, from October 1873 to March 1879. The shortest, of course, is also the most recent, from February 2020 to April 2020. Since the end of WWII, recessions have been shorter on average. This may be a sign that modern monetary policy is successively providing economic stimulus when needed.
Interestingly, the relationship between a recession’s length and the size of the economic contraction during the period is only slightly positive over this period. In addition, research by Russell Investments found that in all the recessions since 1869, the correlation between the decline in GDP and equity market performance was nearly zero. As financial commentators frequently remind us, the stock market is not the economy.
There have been ten recessions since the S&P 500 Index was introduced in 1957. Perhaps surprisingly, the S&P 500 index has seen positive returns during four of the last ten recessions, including the double-dip recessions of the early 1980s when the Federal Reserve was last trying to tame inflation that was running above target.
In these periods it is common for the index to decline before the official start of the recession. This is because financial markets are forward-looking, and markets begin to price in the risk of an economic slowdown long before that slowdown becomes evident in the data. But the market is not always right. Economist Paul Samuelson once quipped that “the stock market has predicted nine out of the last five recessions.” So, a downturn in equity markets does not always mean a recession is on the horizon.
However, when a recession is underway, this forward-looking nature of markets means that equity markets tend to recover before the next expansion begins. In the 13 recessions since the end of WWII, the market reached its bottom roughly four months before the end of the recession. Similarly, a recent study found that in the nine recessions since 1957, excluding the brief COVID-19 recession, the S&P 500 has seen a 12.9 percent average return in the final three months of the recession.
An investor might be tempted to think that they could time the market such that they avoid any drawdown early in the recession but capture the potential upside in the waning months before the next expansion begins. Attempts to time the market are rarely successful but timing the end of a recession is particularly challenging. The National Bureau of Economic Research (NBER) is the official arbiter of when a recession starts and ends, and they tend to do so with a long lag. For instance, the NBER determined that the Great Recession ended in June 2009, but that announcement was not made until almost 15 months later, on September 20, 2010. It often takes many months of economic data for the NBER – or an investor trying to time the business cycle – to be confident that a new economic expansion has begun. While they wait, they may miss out on the opening stages of the market recovery.
This does not mean an investor should sit idle. There will be opportunities to position portfolios to limit downside during a possible recession while positioning for the eventual recovery. Weathering recessions is an unfortunate part of being an investor. Remember that a recession in 2023 is far from a foregone conclusion. The economic data is encouraging, and the Federal Reserve has the tools to stimulate the economy if needed. However, if one comes, it will likely not be your first as an investor, nor your last. As ever, the wise strategy is to remain invested and focused on long-term goals.
David Allen, CFA, CFP
Chief Investment Officer
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