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One of the primary drivers of market volatility over the last few months has been concerns about whether we are headed for a recession. Daily stock and bond prices have responded quickly and sharply to news that either reinforced concerns of an upcoming recession or suggested we may avoid one. The question of whether we are entering a recession is rightfully important to investors, as a contraction of economic activity reduces corporate earnings and puts downward pressure on stock prices. Bond investors are also impacted as lower economic growth usually means lower inflation, lower interest rates, and higher bond prices. So is a recession imminent? And if so, what should an investor do about it?

Recession Obsession

Those who believe the U.S. is headed for recession generally cite a weakening global economy, a lack of U.S. business investment, and a decline in U.S. manufacturing. The general argument is that the U.S. economy cannot continue to be strong when economic growth in Europe and China is weakening. U.S. trade policy has also been a drag on economic growth as it has created an environment that makes it difficult for businesses to invest for the long run. In contrast, those who believe we will avoid a recession point out that unemployment is at a 50-year low and that wages are generally increasing, which has led to healthy levels of consumer spending. An accommodative Federal Reserve is another reason some believe a recession can be avoided.

So which side is right? Recessions are a normal part of the business cycle and we are currently experiencing the longest period of U.S. economic growth in our history. It would not be surprising if a recession occurred sometime in the next few years. Although it is likely that a recession will come at some point, it is extremely difficult to predict when it will happen. In a recent survey by the National Association for Business Economics, 38% of economists surveyed believe a recession will occur before the end of 2020.1 The good news (or bad news if you are an economist) is that economists have a poor track record when it comes to such predictions. A study conducted by the International Monetary Fund in 2018 showed that economists had failed to predict the majority of recessions in 63 countries over a 22-year period.2

But let’s just assume for a moment that the economists who have predicted the recession next year are correct. Should we sell a portion of our stocks now? If you look at the 12 recessions since World War II, the data suggests it might be unwise to do so. Stock returns, as measured by the S&P 500 Total Return Index, have been positive during the six-month period preceding a recession 6 out of 12 times. Stocks have also had positive returns during the 12-month period before a recession 10 out of 12 times — with an average 12-month return of 7.0%.3

If you assume it is too soon to reduce risk because of the possibility of a recession, it is only natural to ask whether we should consider selling stocks once the recession actually occurs. The problem with this thinking is that investors usually don’t know for sure whether we are in a recession until long after one has begun. Economic data used to determine a recession are backward-looking and subject to numerous revisions. In addition, markets don’t wait for a recession to be officially declared to begin to reflect a contracting economy. Some of the worst bear markets occurred approximately around the period of a recession but the timing of the decline in GDP growth does not line up perfectly with the start and end of the associated bear market.

Bear markets associated with recessions, regardless of their timing, can be quite severe and can test the discipline of many investors. Two of the worst bear markets in the post-World War II period have occurred in just the last 20 years and coincided (though not exactly) with the last two recessions.

It is important to point out, however, that stock returns have been higher than normal after recessions have ended. The S&P 500 Total Return Index has averaged a return of 16% for the one-year period after a recession has ended during the post-war period. This performance compares favorably to an average annual return of 11% for the entire post-war period. The index has also averaged a cumulative return of 45% during the three years after a recession ends and has averaged a cumulative return of 91% over the five-year post-recession period.4 Given this tendency for stocks to perform strongly coming out of a recession, investors that sell out of stocks risk missing these early gains as they wait for clearer signs that the economy has turned the corner.

Given the unpredictability of recessions and the problems related to their timing and measurement, investors are unlikely to be successful with a timing strategy designed to avoid market declines during a recession. Instead, investors should focus on being prepared to weather the inevitable recessions when they do occur. Your B|O|S advisor plays a key role in this regard by helping you understand the potential impact on your portfolio’s value during a major stock market sell-off and designing your investment strategy so that you are positioned to remain on track through these inevitable hard times.

Glossary:

S&P Total Return Index: S&P Total Return Index: S&P Total Return Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies that includes the reinvestment of dividends. An index is unmanaged and not available for direct investment.

Footnotes:

1. National Association for Business Economics, “Economic Policy Survey,” August 2019

2. “How Well Do Economists Forecast Recessions?”, International Monetary Fund Working Paper, March 5, 2018

3. B|O|S Research using S&P 500 Total Return Index data from Dimensional Returns Web

4. B|O|S Research, S&P Total Return Index data from Dimensional Returns Web

Filed under: Investing

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