Recessions are the part of the business cycle that removes economic deadwood and sets the stage for the next expansion. Debt is reduced because weaker consumers and businesses default and stronger borrowers reduce spending. Failed projects and ideas are written off and no longer suck capital into black holes. The bubbles deflate. Frauds are exposed and punished. Workers are moving, retraining and otherwise positioning themselves for future economic growth. Companies are refocusing on the most promising areas. Obsolete companies disappear, paving the way for innovations.
As painful as they are for individuals and businesses, long-term equity investors should welcome recessions. The stock market peaks on average seven months before the onset of a recession. The last peak in equities on an inflation-adjusted basis was in November 2021 and prices have fallen more than 20% since. If a recession is declared today, it likely started around January 2022. Is it better for investors if the first six months of 2022 were a recession, or if the economy was still in its expansion phase?
Looking at the last 30 U.S. recessions as defined by the National Bureau of Economic Research, stock declines of more than 20% followed by recessions within four months meant an average recession length of 10 months in which the actual total stock return was negative. 21%. These were followed by bull markets averaging a total real return of 135%. This means that an investor who bought at the peak before the recession rose 85% after inflation at the market peak that followed.
Stock declines of more than 20% that were not followed by recessions within four months were much worse for investors. First there was an average of 13 months without stocks returning to the previous high. This was followed by a 20-month recession on average. Inventory losses were only a little larger than for the first set of declines – down 26% on average from 21% – but the subsequent recovery was much weaker – up 72% from up 135%. As a result, the actual peak-to-peak total return for a 20% equity decline followed quickly by recessions was over 85%, whereas it was only over 27% if the decline 20% was not quickly followed by a recession.
An obvious explanation for this pattern, though I can’t prove it with detailed analysis or data, is that efforts to delay and lessen the pain of recessions make them last longer and fade less. If we are not in a recession today, it may be because the Federal Reserve has kept interest rates so low for so long and the government has engaged in so much stimulus. While these can make life easier for individuals and businesses and push back the date when the recession hits, they can cause more pain and less gain in the longer term.
The other simple story is that the negative gross domestic product growth in 2022 is caused by supply chain issues, difficulties in reopening, and high energy and commodity prices due to the war in Ukraine. . Although we have had two consecutive quarters of negative GDP growth – a popular definition of recession – they could be due to exogenous problems affecting only certain economic sectors, rather than an endogenous cascade of over-indebtedness and misallocated resources across the economy. In this case, the 20% decline in the stock market could be a reaction to a supply-side shock rather than a harbinger of a recession. The stock market could set a new high before the next recession.
Unfortunately, I can’t find any historical parallels for this last story. That may be true, but it doesn’t seem to have happened to the US economy at any time in the last 150 years. The two stories we know to occur frequently are stock market declines followed by quick, brief, and shallow recessions and robust later expansions, and stock market declines followed by delayed, long, and deep recessions with anemic later expansions. If those are the two choices, investors should hope that we are in a recession.
More other writers at Bloomberg Opinion:
• It is far too risky to assume that the bottom has been reached: John Authers
• Why did equities take off from their fundamentals in July? : Mohamed El-Erian
• Are we in a recession? Don’t Ask Wikipedia: Stephen L. Carter
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.
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