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Recessions and Bear Markets: The Connection Isn’t as Close as You Might Think

Have recent economic and capital markets developments made you nervous? What if we throw in recent stock-market volatility? It has led some investors to worry that the odds of a recession have risen—along with the risk of a significant market downturn.

Some investors are nervous now because they assume an economic recession will lead to a decline in corporate profits, which may push stock prices down.

It may sound like a plausible assumption. However, it also could be wrong. Interestingly, the historical record suggests the link between recessions and bear markets is not a tight one. Over the past 11 recessions (as defined by the National Bureau of Economic Research) the Standard & Poor’s 500 Index posted an average annualized return of 12.1%—a percentage point and a half higher than the index’s 81-year annualized return. All told, market returns have been positive in seven of the past 11 recessions.

What’s particularly noteworthy is the S&P 500 has produced an average gain of 32.4% 12 months after the S&P 500 low date during the past 10 recessions dating back to June 13, 1949.  Source:  Ned Davis Research, Inc., January 14, 2008.

Those results may seem illogical, given that recessions usually are bad for corporate profits—and sometimes very bad. Commerce Department figures show that corporate earnings have fallen in all but two of the 10 recessions since World War II—with an average annualized decline of almost 10%.

Standard financial theory teaches that the price of a stock should reflect the stream of earnings it is expected to produce. So, all else being equal, lower earnings should mean lower equity valuations and negative returns.

Page Two: What other factors influence stock prices?


But all things are seldom equal. Other factors frequently influence stock prices, even during recessions. These forces can include:

• Inflation. Inflation has averaged 3.1% per year for the past 20 years.  Rapid price increases above this may create uncertainty about the quality of corporate earnings—and the real value of future earnings. This uncertainty can push down stock prices. Conversely, if an economic slump slows inflation, stock prices might rise, or at least not fall as much as they would have fallen otherwise.

• Interest rates. The Fed typically reacts to a recession by quickly lowering short-term interest rates. We’ve seen this recently, as the Fed has reduced rates aggressively to 2.25%. This is ultimately designed to make money “cheap” to businesses and consumers alike. Long-term bond yields often also decline. For example, the 30-year Treasury bond’s recent yield was 4.50%.  After taxes and inflation, the “real” return is a zero-sum game. Indeed, lower rates increase the relative attractiveness of equities, which can help offset lower earnings.

• Noneconomic shocks. Unexpected bad news, such as a war or terrorist attack, can drive stock prices down, worsening the impact of a recession. On September 21st, 2001, 10 days after “9-11,” the S&P 500 hit a low point during the 2001 recession. Good news like tax cuts, peace deals or mergers, and corporate stock buy-back plans all have the potential to drive stock prices higher, despite a recession.

• Investor psychology. Sometimes markets rise and fall for reasons that seem to have little or nothing to do with economic fundamentals. The 1987 bear market, for example, occurred at a time when economic growth was accelerating. It’s also important to understand that financial markets tend to be forward looking. That is to say, prices are usually influenced by what investors expect to happen, not what has already happened.

Page Three: Past performance may not guarantee future results, but looking at the past can’t hurt.


Periods before a recession often see a spike in market volatility, as investors react to rising uncertainty about the direction of earnings. In seven of the last 10 recessions, profits also peaked before the economy did, giving investors additional reason to be cautious. By the same token, however, the market often hits bottom and starts to recover before the economy does—as investors begin to anticipate a rebound in earnings.

Past performance is no guarantee of future results, but history suggests that recessions, like bear markets, are short-term corrections in a longer-term rising trend. Investors who have tried to second-guess the market—for example, by exiting the stock market when they thought a recession was at hand and jumping back into the market when they thought the economy had hit bottom—often have been disappointed.

For example, consider that $10,000 invested for the 10 years ended 12/31/06 would have grown to $19,147 – if an investor was invested for all 2,516 market days.  If the investor missed just the 10 best days, his return was reduced to $11,937.  The best 20 days missed?  $8,224. The best 30 days?  Also a negative number, resulting in $5,902.  Source:  American Funds. Hence the common-cited adage, “Time in the market, not timing is what matters.”

With longevity increasing, the risk of outliving one’s money increases.  The average 65-year old couple today, for example, has a 92% probability of one spouse living to age 92.  A newborn baby girl today has a 33% chance of living to 100. Indeed many people will spend more time in retirement than they did working.  With time, we know that principal risk goes down – and purchasing power risk goes up.  Consider that with a 3.1% inflation rate, we will need double the income we have today in just over 20 years, to maintain our same purchasing power that we have today.  Regarding principal risk, there has yet to be a 10-year time period dating to 1934 where stocks have not been positive.  Even looking at 5-year periods of time from 1977-2006, we know the S&P 500 has been positive 88% of the time.

For most investors, the wisest course is to develop a long-term investment strategy and stick to it, even during market corrections and economic downturns. 

Contact me today at (410)494-8097 for a complimentary copy of “Building Portfolios for All Ages by Dr. Richard Marston, Director of the Institute for Private Investors at The Wharton School.

Ben Proctor, CFP®, is a Vice President – Wealth Management with Smith Barney’s Greenspring Station office.  He can be reached at (410)494-8097 or via his web-site at www.fa.smithbarney.com/benproctor .

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