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This is why stock investors should be hoping that a recession has begun

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This is why stock investors should be hoping that a recession has begun

A debate has erupted over whether the US economy is in recession. Everyone agrees that a recession is a reduction in real economic activity, but there is no consensus on how deep, broad, and prolonged a recession must be to merit label “recession”..

Economists can debate theories and politicians can explain why the other side is to blame, but investors should focus on the data.

Recessions are the part of the business cycle that clears the economic deadlock and sets the stage for the next expansion. Debt is falling because weaker consumer and business borrowers are defaulting and strong borrowers are cutting spending. Unsuccessful projects and ideas are written off and no longer drain capital into black holes. Bubbles are blown. Fraud is exposed and punished. Workers are moving, retraining and otherwise positioning themselves for future economic growth. Business will be reoriented to the most promising areas. Obsolete enterprises are fading away, clearing the ground for innovation.

Although long-term equity investors are very painful for individuals and companies, recessions are to be welcomed. The stock market peaks on average seven months before a recession begins. Equity’s last inflation-adjusted peak was in November 2021, and prices have fallen more than 20% since then. If a recession were to be announced today, it would likely begin around January 2022. Would investors be better off if the first six months of 2022 were a recession or if the economy was still in an expansionary phase?

Looking at the last 30 US recessions as defined National Bureau of Economic Researcha drop in equity of more than 20%, followed by a four-month recession, meant that the recession averaged 10 months, during which real total stock returns were negative 21%. These were followed by bull runs with total real returns averaging 135%. This means that an investor who bought at the pre-recession peak is up 85% after inflation before the next market peak.

A fall of more than 20% in capital, which was not accompanied by a recession for four months, was much worse for investors. First, there was an average of 13 months without inventory returning to the previous peak. This was followed by a 20-month decline in the average. Stock losses were only slightly greater than in the first group of declines, averaging 26% versus 21%, but the subsequent recovery was much smaller, plus 72% versus plus 135%.

As a result, the real compound peak-to-peak return for a 20% decline in capital quickly followed by recessions was plus 85%, while it was only plus 27% when the 20% decline was not quickly followed by a recession.

One obvious explanation for the pattern, though not one that I can prove with detailed analysis or data, is that attempts to delay and soften the pain of recessions make them last longer and clear less. If we are not in a recession today, it could be because the Federal Reserve kept interest rates so low for so long and the government provided so much stimulus. While they may make life easier for individuals and businesses and push back the date of recession, they may cause more pain and less gain in the long run.

Another simple story is that negative GDP growth in 2022 is caused by supply chain issues, recovery issues and high energy and commodity prices due to the war in Ukraine. Although we have had two consecutive quarters of negative GDP growth – one of the popular definitions of a recession – this may have been due to exogenous problems affecting only certain sectors of the economy, rather than an endogenous cascade of excess debt and misallocation of resources across the entire economy. In that case, a 20% drop in the stock market may be more of a response to a supply shock than a harbinger of a recession. The stock market may reach a new high before the next recession.

Unfortunately, I can’t find any historical parallels for this last story. That may be true, but that doesn’t seem to have happened to the US economy in the last 150 years. Two stories we know happen frequently are stock market crashes followed by quick, brief, shallow recessions and strong subsequent expansions, and stock market crashes followed by delayed, prolonged, deep recessions with anemic subsequent expansions. If those are the two options, investors should be hoping we’re in a recession.

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