Broker Check
Stocks in Recessions

Stocks in Recessions

May 08, 2023

Key Takeaways

  • Investors and economists increasingly expect to see a recession in the U.S. in 2023.
  • Historically, recessions have ushered in major drawdowns from prior equity market peaks, but have preceded major rebounds in the months that follow.
  • It is unclear whether and when the U.S. will enter a recession, and if it does, the impact that it could have on equity markets.
  • Focus on your long-term financial goals and work with your financial advisor to ensure your plan can withstand market turbulence.

Despite solid economic growth over the past few quarters, most economists think the U.S. will enter a recession in 2023. If the U.S. does enter a recession, it is important to revisit your financial plan with your advisor to ensure you remain on track to achieve your financial goals. Sticking with a plan can be difficult when we see alarming news headlines and heightened financial market volatility. As long-term investors, it can be useful to consider how U.S. equity markets have behaved before, during, and after recessions historically. Understanding that stock markets follow cycles, and that they have always rebounded eventually, can help ease the emotional challenges that can accompany turbulent markets.

Recessions in the U.S.
According to the National Bureau of Economic Research (NBER), there have been 11 recessions in the U.S. since 1950. But what is a recession? The NBER defines a recession as a significant decline in economic activity that is spread across the economy and that lasts more than a few months. This is far from a clean definition, and is certainly different from the common understanding of a recession as two consecutive quarters of negative GDP growth. To determine recessions, the NBER considers each economic contraction’s (1) depth, (2) diffusion (i.e. how broadly it is spread across the entire economy), and (3) duration. To complicate matters, the NBER does not consider each criterion in a vacuum, stating that “while each of the three criteria…needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another.” Given the vagueness of the definition, it is no wonder that the topic of recession is presently at the center of so much debate.

There have been 11 U.S. recessions since the early 1950s. The table below lists the recessions, along will their durations and proximate causes.

Source: ycharts.com

Stock Performance during Recessions
Using history as a guide, what can we expect from equity markets before, during, and after a recession? The table below shows the returns of the S&P 500 during each of these periods:

 
Source: ycharts.com

Judging by this data, there doesn’t seem to be much to worry about. In the past 70 years, stock markets have fallen a modest 1% during recessions and have rebounded strongly in the subsequent 12 months. Stocks tend to fall in the periods immediately preceding recessions as markets begin to anticipate a slowdown in business activity and company profits. Nevertheless, losses during these periods have been modest.

Of course, this doesn’t tell the whole story, because markets are forward-looking. Investors forecast the turns in business cycles before they are complete. As a result, we have historically seen stock prices begin rising long before recessions are over. Similarly, economic headlines usually continue to worsen after the markets find a bottom. Waiting for the all-clear signal? You will likely be too late and will miss the biggest gains of the recovery.

The below chart is a better representation of the investor experience around recessions. It shows each recession’s peak-to-trough decline (i.e. percentage drop from the stock market’s prior high water mark to its lowest value during the recession) and the subsequent 6- and 12-month return off that bottom:

 
Source: ycharts.com

From peak to trough, the S&P 500 has historically fallen about 30% (not including dividends) in recessionary periods, a sharp difference from the “modest losses” suggested by the prior chart. Investors that were able to withstand these market declines, however, would have been rewarded with strong stock gains off the market bottom. On average, the index has been up about 40% one year after each recession’s low point. Investors that sell out of the market after a major equity decline will inevitably miss out on the significant rebounds that typically follow, which can have a huge impact on their long-term financial success. This is why it is so vital to work with your advisor to ensure your portfolio is aligned with your risk tolerance – so you can remain invested throughout these inevitable declines.

What About Today?
Why not simply sell today ahead of a potential recession and avoid the drawdown altogether? After all, there are signs that the U.S. economy is slowing. Growth in gross domestic product has slowed from 3.2% (annualized) to 1.1% over the past six months. The housing market remains in a steep decline as home buyers grapple with higher mortgage rates and elevated housing prices. The sturdy labor market, which has been the foundation of resilience in the U.S. economy over the past 12 months, is starting to show cracks. Monthly job gains have been decreasing and job openings have tumbled. Banking turmoil in the first quarter will likely lead to lower lending for the rest of 2023. Markets are widely expecting a second consecutive quarter of year-over-year declines in S&P 500 earnings.

The problem with selling today is that growth concerns are likely already being reflected in market prices, at least to some degree. How much of a decline is priced into markets (and as an extension, what impact a recession will have on capital markets) is anyone’s guess and is the subject of much debate among market pundits. In 2022, the S&P 500 fell about 20% and reached an intra-year low down 25%. Historical data shows that a 25% decline is only slightly less than the average peak-to-trough drawdowns for prior U.S. recessions. Of course, a recession never materialized in 2022, and historically, the S&P 500 has never bottomed before a recession has started.

Was 2022’s bear market an adequate market discount for a coming recession? Could stocks bottom before a recession begins and rally through it? History suggests it is unlikely, but anything is possible in equity markets. We won’t know until after the next recession begins, whenever that is.

Bear markets can be difficult for investors. It is unclear as to whether and when the U.S. will fall into recession, and the impact that doing so will have on stock markets. What is clear is that periods of market turbulence (and even the low points that accompany recessions) create the best buying opportunities for those that remain disciplined. To ensure you are positioned to take advantage of these opportunities, investors should plan ahead. This entails working with your advisor to construct a well-diversified portfolio, build a plan to reach your financial goals, and maintain disciplined to stay invested during turbulent markets.