With talk about a recession widespread, investors are naturally concerned about what will happen to their stocks if a recession actually occurs. Is it time to sell stocks to avoid further declines if the economy continues to weaken? Is it a good time to buy stocks cheaply before a recovery raises prices? Should an investor just ride the recession out?
To put these questions in perspective, we should look at what stocks have done in the past. A recent study by Ned Davis Research gives us valuable information about how the stock market has responded to the ten recessions since 1945.
Davis Research found that the stock market typically hit a new high about six months before a recession officially began. When the economy was in a recession, stocks usually continued to go down for another six months, but then started to recover three to six months before the recession ended. After hitting their low point, stocks tended to lead the economy out of the recession and generally had an exceptionally good year after the recession’s low point.
The numbers indicate that from the top of the economic cycle to bottom, stocks declined an average of 20%; about half of that loss usually occurred before the recession began. Recessions normally lasted 10 to 11 months. Once the bottom was hit (which is usually when sentiment is at its worst level), the market rallied an average of 32% over the next year. Often, the stock market exits a recession at a level higher than when it entered the recession.
Though the pattern outlined above appears simple to understand, it is surprisingly difficult to use effectively. Here are the problems with implementing a market-timing strategy based on trying to track recessions:
- We only find out that a recession has begun long after it started. Recessions are officially declared by the National Bureau of Economic Research (NBER) after the economy experiences two consecutive calendar quarters of negative growth, and NBER might not make that declaration for a year after the fact. That’s much too late for an investor to use the information.
- Stocks often go down, but no recession follows. Paul Samuelson, Nobel prize-winning economist, once quipped, “The stock market has forecast nine of the last four recessions.” Therefore, we cannot use a decline in stock prices as a perfect predictor that a recession will follow.
- Each recession and recovery is unique and so is the stock market’s reaction. In three of the past four recessions, stocks actually gained ground. In the recession from July 1990 to March 1991, for instance, the S&P 500 rose 2.5%, despite a severe sell-off in the summer of 1990. And in the recession from January to July 1980, stocks climbed nearly 6%. On the other side of the coin, in the last recession, which ended November 2001, stocks continued to fall for 12 months after the recession was officially over.
There are other issues that add complexity to the investment decision. Some stocks do better in recessions than others. Health care and consumer staples typically perform better than average during the beginning of a recession, while financial companies and retail stocks do poorly. Buying a broad basket of stocks might not be the best way to profit in a recession or a recovery.
If we knew for sure when a recession would begin, we could sell stocks six months before the recession began and buy them back one year later when the economy was in the middle of the recession. But we don’t have that information—and no one else does either.
Since we do not know when the recession will occur, BWFA believes that the safest way to invest in stocks is to hold good stocks through recessions. Good stocks might decline during a recession—we’ve seen very healthy companies lose 40% of their stock price—but recover just fine in the long term.
During this economic cycle, BWFA started to reduce our stock holdings in September 2007, which was in advance of the stock market’s peak in October. Now economists are speculating whether a recession began in December or is about to begin soon. We are still holding high cash positions in our client accounts, but are beginning to think about what stocks to buy next when we see the stock market making its recovery.