The Stock Market and a Recession

It seems that the main economic question in the media is whether or not the United States economy is in a recession. The answers from the experts, including the political pundits, are not conclusive. In fact, different experts give us different definitions for the word “recession”.

The real question for an investor is: How does the stock market perform in a recession? A recession is a normal part of the business cycle and does tend to occur at least once a decade. If recessions occur periodically, then we can study them and learn how to invest when one occurs.

Investors have the option to purchase stock in an individual company or a grouping of stocks in an index. The performance of a stock index invested in the largest 500 U.S. companies, also known as the S&P 500 index, is shown for the last 5 recessions.

S&P 500 Index Performance During The Past 5 Recessions

Overall Recession Period: # of Months//First Half//Second Half//Total
December 1973 - March 1975:16//-17.4%//5.1%//-13.1%
February 1980 - July 1980:6//-6.9%//14.5%//6.6%
August 1981 - November 1982:16//-14.5%//23.7%//5.8%
August 1990 - March 1991:8//-9.5%//16.5%//5.4%
April 2001 - November 2001:8//4.4%//-5.9%//-1.8%
Average Since 1953 - 1954: //-8.6%//13.2%//3.1%
Source: Citigroup Global Markets

Each recession is unique and the length, severity of the downturn, and magnitude of the rebound cannot be predicted. The period from December 1973 – March 1975 had the largest downturn at 17.4%. The latest downturn in the S&P 500 index started in October 2007 and has gone through March 2008 with about a 20% reduction in value, eclipsing the previous mark. If you believe that we are in a recession, the data says that a 20% decline is about as bad as it gets.

Generally, the S&P 500 index does perform better in the second half than the first half of a recession. An investor needs to understand the reasons why this can occur. Insight can be gained by looking at market timing, leading versus lagging indicators, and the relationship of the S&P 500 index with a change in interest rates.

Market Timing

No announcement occurs when the S&P 500 index is at the top or bottom of a cycle. History tells us the date and value when the top occurred and when the bottom occurred. In fact, the low of March 2008 may not be the low of the cycle. We only know the dates for the first half and the second half after the recession is over.

When the S&P 500 peak occurred in October 2007, no warning signs flashed on the TV screen or were printed in the newspaper. If a prophet did say it, would an investor believe it? Human nature tells us probably not.

It is hard to comprehend the idea that stocks should be sold when the news is good. It is equally hard to comprehend the idea that stocks should be bought when the news is bad. What is the bottom line for an investor? You cannot time the market.

Leading versus Lagging Indicators

The official announcement of entering a recession or leaving a recession is a lagging indicator. At some point in the future, an economist will tell us the date when a recession started, when it ended and the halfway point. Do not use a lagging indicator to predict the future.

The S&P 500 index is more of a leading indicator because investors are making buy and sell decisions on a value in the future. This most recent decline in the S&P 500 index is suggesting that our economy is in a recession.

An investor should not use the official announcement that we are in a recession to buy or sell stocks or the S&P 500 index. Why? A lagging indicator cannot predict the performance of a leading indicator.

Relationship with Interest Rates

As the economy slows down, the Federal Reserve lowers interest rates. As the interest rate drops, the return on a bond, CD, bank account, or money market account goes down, making them less attractive to an investor. People are more attracted to these types of investments when the interest rate is high and less attracted when the interest rate is low.

As the interest rate and the S&P 500 index fluctuate, an investor considers the appropriate to move from one investment alternative to another. In a recession when both the interest rate and S&P 500 index price have gone down an investor will consider the right time to purchase stock or a stock index. This occurs when the interest rate is sufficiently low and the price of the S&P 500 index has gone down enough in value that an investor believes the future reward of owning the S&P 500 index is worth the risk of it going down even further.

This suggests that an inverse relationship exists with interest rates and the future direction of the S&P 500 index. Higher interest rates tend to make fixed return assets, like bonds, more attractive and the S&P 500 index less attractive. The reverse happens for lower interest rates.


Summary

A long-term investor should realize that recessions do occur. An announcement that it has occurred is not a good indicator of the future direction of the S&P 500 index.

Is now a good time to buy the S&P 500 index? Yes, relative to October 2007. Since the value of the S&P 500 index is about 20% lower than in October 2007 it means that it has essentially gone on sale. If you were happy to buy it in October 2007, you should be even happier to buy it when it is cheaper. Also the drop in interest rates from October 2007 until now makes the S&P 500 index more attractive.

Human nature tells us that it is more difficult to purchase the S&P 500 index when the news is bad. Invest using data rather than emotion. Do you really want to pass up a 20% off sale?