This “Throwback Thursday” article comes from AAII’s extensive archives spanning four decades. While these articles may have been written long ago, the investment topics they cover are just as relevant today as they were when they were written. We are pleased to reintroduce them to a new audience.
Recessions and Recovery: How the Stock Market Behaves
Bear stock markets and economic declines fill some investors with a sense of impending doom. Sometimes, this results in a movement away from stocks.
But the economy—and stock market—is cyclical, and what goes down has, historically at least, always come back up, and even advanced further.
While the outlook may currently appear bleak, it may be useful to examine past stock market behavior after recessionary increases in the civilian unemployment rate.
In August 1990, the civilian unemployment rate, at 5.6%, was 0.6 percentage points higher than the cyclical low of 5.0%, which was experienced in March 1989. There have been nine other cases of a cyclical increase in the unemployment rate of this magnitude and, if the U.S. economy was not already in a recession, it experienced a business peak in less than a year.
By the end of 1990, the unemployment rate was up to 1.1 percentage points higher than the cyclical low. To many economists, the question is not whether we are now in the midst of another recession, but how bad it will be.
Economic Recessions and the Stock Market
Economic recessions are particularly interesting from a financial point of view, since they have always provided some excellent opportunities to acquire common stock at bargain prices. In trying to take advantage of economic adversity, however, it should be appreciated that the stock market is a leading economic indicator.
In a massive compendium that was published in 1961 for the National Bureau of Economic Research, Geoffrey Moore and his associates found that common stocks were excelled as a leading indicator of business cycles only by the net change in the number of operating businesses. Up to that time, stock prices were classified as being a leading indicator 31 times, roughly coincident 14 times, and a lagging indicator only five times.
The most publicized weakness of stock prices as an indicator of economic activity is a propensity to have predicted more economic recessions than have actually occurred. Excluding the most recent market decline, there have been nine occasions since the end of World War II when the S&P 500 index lost 20% or more of its value, and only five of these declines were associated with economic recessions. The most dramatic example of a market decline that did not immediately precede a recession was the October 1987 stock market crash.
The more recent stock market decline may or may not be a different story. From an S&P 500 value of 368.95, an all-time high that was achieved on July 16, 1990, the market dropped to a low of 295.46 on October 11, 1990, a loss of almost 20%.
One would hope that the U.S. economy is now more recession-proof than it used to be, and that the current bear market is not indicative of a serious recession. Most business enterprises, however, are now preparing themselves for such an event and in the process they may very well help to trigger the ninth recession since quarterly figures for our national income and product accounts were first computed, beginning in 1947.
Recoveries and the Stock Market
While the stock market has not been a very reliable predictor of economic recessions, it has been a very superior predictor of economic recoveries. If we ignore the money supply, which has not exhibited a distinct trough during some recessions, stock prices can claim the distinction of being the only component of the index of leading economic indicators that has consistently led economic recoveries in the post-World War II period.
The recovery lead times for the revised index of leading economic indicators, which was published in February 1989, range from a low of only one month for the 1973 to 1975 recession, to a high of 10 months for the 1960 to 1961 and 1981 to 1982 recessions. The lead times for stock prices, on the other hand, fall in the comparatively narrow range of from three to eight months.
The stock market’s propensity to explode upward before the economy has bottomed out means that, for best results, an investor should buy stock while the economic outlook is still rather bleak and the unemployment rate is continuing to increase.
In the 1947 through 1989 period, one could have always achieved price appreciation amounting to at least 14.8% one year later by purchasing a portfolio similar to the S&P 500 at the end of the month after a cumulative increase in the civilian unemployment rate equal to 0.9 percentage points or more for the preceding month. In half of these recessionary cases, one would have acquired the S&P 500 after its bear market trough and in the other four cases, it would have been advantageous to wait for a cumulative increase in the unemployment rate in the 1.2 to 1.8 percentage point range. Over the 0.9 to 1.8 percentage point range, there is remarkably little difference in the average following-year price appreciation associated with the S&P 500 (see Table 1).
The advantage to buying stock after an increase in the unemployment rate of only 0.9 percentage points is that the second-year price appreciation has been better, on average, than for larger increases in the unemployment rate. The second-year price appreciation of 9.1%, however, is only about one-third as great, on average, as the first-year price appreciation of 26.4%.
In the post-World War II period, the civilian unemployment rate has so far always increased at least 2.2 percentage points, and in one case by as much as 5.5 percentage points, before an economic recession was over. The average following-year gain from owning a portfolio similar to the S&P 500 declines, however, after a cumulative increase in the unemployment rate in the vicinity of 1.8 percentage points. Waiting until the unemployment rate has increased 2.2 percentage points or more not only increases the risk of missing a recessionary opportunity to acquire stock at a bargain price, but also increases the risk that the one-year holding period appreciation will be zero or negative.
As of the end of December 1990, the civilian unemployment rate had increased 1.1 percentage points above the cyclical low of 5.0% that was experienced in March 1989. This increase appears to be large enough to make one fairly certain that the U.S. is in the midst of another economic recession, making common stocks an attractive investment from a historical point of view.
It should be noted, however, that the low value for the S&P 500 has usually occurred not more than about a year after an unemployment trough and that a record 19 months elapsed between the March 1989 unemployment trough and the October 11 closing low of 295.46 for the S&P 500. Thus, it is quite possible that the S&P 500 has already experienced most of its “recessionary” trough.
While the war in Iraq muddies the picture, the current recession may provide opportunities for those willing to bet on the market when the picture is bleak.
This article was written by Edward Renshaw and David Molnar for the February 1991 issue of the AAII Journal. At the time, Renshaw was a professor of economics and finance at the State University of New York at Albany and Molnar was a student at the State University.
