What Happens During a Recession?
Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.
— Warren Buffett
Of late, the use of the dreaded “R” word has increased. Whilst inflation and the ongoing Russo-Ukraine war has been blamed, hawkish central banks like the Fed have been pointed out as the recent culprits. A check on Google Trends also shows that this is likely at the forefront of many people’s minds given the spike in interest over the course of this year. Mortgage rates and the performance of stock markets are also topics of rising interest.
True to form, financial media have jumped on this topic and are pushing out opinions from billionaires, banks, investment managers and just about anybody who wants to appear smart, on the breadth, depth and scope of the “upcoming recession”. So what does all of this mean to you and your money?
There Are Many Forecasts of the Upcoming Recession
Experts with their data, and their reading of world economies should be able to give us a reasonably accurate prediction of any recessions - which should enable you to brace for the upcoming slowdown, correct? Unfortunately, no!
The following two studies by the IMF on their, and private sector forecasting ability shows that strategists are woefully wrong all the time (Zidong An; João Tovar Jalles; Prakash Loungani (2018), How Well Do Economists Forecast Recessions?, IMF Working Paper & Prakash Loungani (2000), How Accurate Are Private Sector Forecasts: Cross-Country Evidence From Consensus Forecasts of Output Growth, IMF Working Paper).
To quote a phrase from one of the studies; the record of failure to predict recessions is virtually unblemished. The diagram below shows the accuracy of the forecasts.
The black line denotes the actual growth rate (negative because of the recession). The forecasts up to 1 year in advance of the event are cheerily high. Even in the run up to the actual slowdown event, forecasters are slow to adjust their predictions to reflect the actual ongoing conditions - never really getting the right numbers.
The table below breaks out the data more granularly. You may agree that forecasting is difficult — pre 2008, forecasters missed 100% of the recessions 1 year in advance. Post 2008, with greater awareness, better datasets and computers to help processing; forecasters did a little bit better — missing 94% of all recessions 1 year in advance!
Even during the year of the slowdown where the deterioration of the economy should be more apparent, 30% to 65% of the forecasters still missed getting the recession call correct.
So with forecasts and predictions often going woefully wrong, what else can one do?
Recessions Will Make Markets Go Down
Like the economy, the stock market is cyclical so many assume that losses in the market should coincide with a contraction in economic growth and vice versa. It may happen, but not as often as you think. In his book “Stocks for the Long Run”, Jeremy Siegel noted that since WW2, markets have fell double digits 13 times, without being triggered by a recession.
So does recessions automatically mean market losses? This chart of returns for the past 95 years can paint you the story. The top left quadrant shows that there are many instances where there has been negative growth (recession), but market returns have been positive. The bottom left quadrant shows that there have also been negative returns during recessions, but the number of instances are far less than expected.
A Recession Is a Reason to Sell
Guess what? A study of markets indicates that we could well be in a recession before some authority makes the call on it. One of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does.
The chart below shows official recession periods (highlighted in grey), stock market price (blue line) and the actual official announcement of recessions.
The takeaways for you are; by the time the recession is announced, the stock market sell-off is near the end or over. In addition, recessions do not automatically equate to a 2008-type sell-off as there are varying degrees of slowdowns.
Wait for Things to Get Better Before Investing
As advisors and partners who journey with investors, we have heard this statement numerous times through the years. It becomes more pronounced when markets are down, news is pessimistic and uncertainty is high.
If we hadn’t already emphasised enough - stock and bond market prices take into account what could happen in the near future. As such, it already starts going down when things are expected to be bad and climbs in anticipation of things getting better.
The chart below shows that markets start moving up months before the end of a recession. This means stocks are making gains when things are bleak. Waiting for the end of the recession or for better news means you are sitting at the side, giving up good double digit gains.
If you pride yourself as someone who does their stock market homework and likes to analyse fundamentals, then the following data may surprise you. Company earnings and sales bottom months after the end of the recession.
So if you were waiting for valuations and signs that companies are turning around, this is bad news. Markets could’ve gone up more than 25% by the time the data looks good. Waiting for things to get better would mean that you missed the boat.
Things look uncertain now and many investors are extremely nervous about the market. However the fear and uncertainty will eventually subside as these points above show. In addition, selling out or holding on to cash during this period would not help - especially with inflation temporarily above average and your financial goals still needing to be fulfilled.
If you need a second opinion, and want a portfolio check-up, contact us for a more intimate and personal discussion.
