While there is no doubt that the U.S. economy will eventually enter a recession, it is important to keep in mind that recessions are not one size fits all and vary greatly in depth and duration. For example, we wrote an article in June of 2020 titled, “Shortest Recession In U.S. History.” We were correct in that assessment as the recession lasted roughly two months as the economy and the markets powered through the impact of the global pandemic. Expansions and recessions are the nature of the business cycle and a part of the journey, not a destination. With the recent equity market declines and other global issues in mind, many investors are wondering if the U.S. has entered into another recessionary phase of the business cycle and what the potential market impacts might be.
To answer that, we can follow the work of the organization responsible for dating U.S. business cycle expansions and recessions and compare those environments to the equity markets at the time.
The National Bureau of Economic Research (NBER) is the organization recognized for defining the phases of U.S. business cycles. The NBER identifies the dates of peaks and troughs that frame economic recessions and expansions. They define a recession is as the period between a peak of economic activity and its subsequent trough, or lowest point.
The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. Their focus is on five key measures of economic health, such as real (adjusted for inflation) personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, and industrial production.
As a result, recessions are a period of falling production, sales, income, and employment that usually lasts more than a few months. Looking at these measures can give us a better understanding of whether the business cycle is in an expansionary or recessionary phase. The following is a sample of current year-to-date data that the NBER uses to determine the phase of the business cycle, sourced from the U.S. Federal Reserve:
As you can see, the measures used to define recession are all currently positive, and we would conclude that we are currently not by definition in a recession. However, we also want to stress that recessions are part of the natural economic cycle.
We can compare the current equity market environment to previous recessionary environments to judge how much recession risk is already priced into these markets. While each recession and the equity market’s response is different, we can still use the data to help form our expectations regarding the potential outcomes. The NBER has identified four recessions since 1990. These four identified recessionary periods are (1) August 1990 to March 1991, (2) April 2001 to November 2001, (3) January 2008 to June 2009, and (4) March 2020 to April 2020 (exhibit 1). Comparing the monthly Wilshire 5000 Index price returns to the NBER defined recession periods (peak to trough, and before the economy begins a new growth cycle), we find the following:
- The equity market fell roughly 10% during the months preceding the start of each recession on average,
- The average peak to trough equity market decline was -30% using monthly data.
- During the recessionary periods in total, the equity market declined 7% on average,
- These recessions lasted about nine months, and
- The equity market bottomed three months before the recession ended, then rallied sharply.
We can draw a few important points from this data. First, equity markets typically fall both before and during a recession. Secondly, equity markets tend to bottom before a recession ends, so it may not be wise to wait to invest until the economic data improves.
Perhaps most importantly, it is very difficult to time the equity market up to and during a recession. Two of the 4 previous recessions included the technology bubble burst of the early 2000’s and the Global Financial Crisis of 2007-2009 that resulted in significant and sustained equity market declines. Those were extraordinary events unlikely to be repeated today. With an average decline of 17% over the entirety of the previous 4 recessionary periods from the equity market peak to end of each recession, recession risks may already be fully priced into U.S. equities currently.
To summarize, a lot of risk has already been priced into the equity markets in our opinion. Even if a recession were to occur, additional downside is likely to be limited. We think that the best course of action is for investors to stay their path according to each their financial plan.
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Wilshire 5000 Index – This Index is a market-capitalization-weighted index of the market value of all American-stocks actively traded in the United States. It is designed to measure the performance of most publicly traded companies headquartered in the United States, with readily available price data.