Swedroe: Stock Performance In A Recession

Even if you get it right, market timing during a recession won’t result in a windfall.

It’s now been more than five years since our last recession. This most recent recession, caused by the financial crisis, officially began in December 2007 and lasted until June 2009, a period of 18 months. It was the longest of 12 recessions, identified as such by the National Bureau of Economic Research, occurring in the post-World War II era.

During that period, the average length of a recession was 11 months. The longest we have gone between recessions was from March 1991 (that recession began in July 1990 and lasted eight months) until March 2001 (a recession that also lasted eight months and ended in November 2001).

A topic of great interest to investors is how stocks tend to perform in recessions. Before answering that question, however, it’s important to note that we often don’t know when a recession officially has begun until much later, and when it has ended until well after it’s over.

That means that even if there appears to be valuable information in the data, you most likely won’t be given an opportunity to put that information to good use. With that said, how exactly have stocks performed during the 12 recessions since 1945?

Surprisingly Positive

While it may come as a surprise to many, the average total return to the S&P 500 Index was a positive 3.9 percent. This, however, was below the 4.9 percent average total return to one-month Treasury bills. Thus, while stocks did produce a positive return during these 12 recessions, there was a small negative equity risk premium.

In other words, there would have been only a slight advantage to timing the market perfectly—getting out of stocks just as a recession was about to begin and getting back into stocks just as it was ending—even if you knew in advance when recessions would start and finish. And of course, no one does know.

Moreover, this small benefit might have been wiped out by taxes and transaction costs. In short, even perfect foresight regarding where the economy was headed might not have provided much of a benefit.

It’s also worth noting that stocks actually outperformed one-month Treasury bills in half of the 12 recessions, and produced losses in just five of them. In the recession from February 1945 through October 1945, stocks outperformed one-month Treasury bills by more than 27 percent in terms of total returns.

And in the recession from July 1953 through May 1954, they outperformed by more than 26 percent, again in terms of total return. The worst gap between returns was in the latest recession, when the S&P 500 underperformed one-month Treasury bills by more than 40 percent. The next worst gap was 7 percent.

Factoring Out 2008

While I’m not suggesting that you should ignore any of the data, it’s interesting to note that if we limited our look back to only recessions that occurred from 1945-2007, omitting the most recent recession and longest recession, there’s a much more favorable picture for stocks.

During those 11 recessions, the average total return for the S&P 500 was 7.4 percent, 2.3 percentage points greater than the return on one-month Treasury bills. Thus, prior to the most recent recession, there was an equity risk premium even during recessions.

One reason for the above results is that the stock market is a leading indicator of economic activity. The punchline of a classic joke is that the market has predicted far more recessions than have actually occurred.

With this concept in mind, we can look at the data for the six-month periods immediately leading up to each recession. In the six months prior to the 12 recessions, the average return to the S&P 500 was 0.0 percent. Thus, on average, even in the six months leading up to a recession, stocks didn’t produce losses. And in six of the 12 periods, the returns were positive.

The worst return was in the six months prior to the recession that began in September 2000, when the S&P 500 produced a loss of 17.8 percent. The best return was in the six months prior to the recession that began in May 1948, when the S&P 500 produced a gain of 9.8 percent.

If we look at the data for the three-month periods prior to the 12 recessions, we find that the average return to the S&P 500 was 0.7 percent, while the average return to the one-month Treasury bill was 1.4 percent. Thus, while the S&P 500 did, on average, provide a positive return in these periods (and it was positive in seven of the 12), there was also, on average, a negative equity risk premium (and it was negative in eight of the 12).

Variables Of Recession

Providing us with further insight on recessions is the 2008 study, “What Happens During Recessions, Crunches and Busts?” International Monetary Fund economists Stijn Claessens, M. Ayhan Kose and Marco Terrones studied the key macroeconomic and financial variables around business and financial cycles for 21 countries belonging to the Organisation for Economic Co-operation and Development during the period from 1960 through 2007.

They analyzed the implications of 122 recessions, 112 credit contraction episodes (including 28 crunches), 114 episodes of house price declines (including 28 busts), 234 episodes of equity price declines (including 58 busts) and their various overlaps. Following are some of their key findings:

• The typical recession lasts almost four quarters and is associated with an output drop (decline from peak to trough) of roughly 2 percent.
• Severe recessions are more costly, with a median decline of about 5 percent, and last a quarter longer.
• While typical recessions tend to result in a cumulative loss of about 3 percent, severe recessions cost three times more.
• Recessions tend to be highly synchronized across countries and often coincide with contractions in credit and declines in asset prices.
• Episodes of credit crunches, house price busts and equity price busts last much longer than recessions. The average duration of a credit crunch is around 10 quarters. An asset price bust is usually even longer, with an average duration of 18 quarters in the case of house price busts and 12 quarters in the case of bear markets.
• A much larger decline in the growth rate of investment compared with the growth rate of consumption is a feature both of recessions and of credit crunches and house price busts.
• While the typical house price decline is only 6 percent, the average decline is 11 percent due to some very large declines in the sample. During a house price bust, prices decline by about 29 percent.
• While equity prices start falling before the onset of a house price bust, they usually begin to recover within two years of that event.
• Credit growth experiences a large slowdown and does not return to pre-bust levels for at least three years.
• Recessions with house price busts result in more adverse outcomes than those without such busts.
• Although recessions associated with equity price busts tend to be longer and deeper than those without equity busts, these differences are not statistically significant.

One of the most important findings was that credit crunches and house price busts are more costly than equity price busts, as equity price busts are less consistently associated with real sector outcomes.

The important takeaway is that the track record of economists’ ability to forecast recessions is poor, and there hasn’t been much—if any—advantage from timing the market, even if you happened to know exactly when a recession would begin and end. As a result, trying to time the market based on forecasts of recession doesn’t seem to be a prudent strategy.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.