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Recessions and bear markets are two of the most significant economic events that investors need to be aware of. While discussions about recession probabilities usually arise when there are major upheavals on the stock market, it’s important to note that not all recessions lead to bear markets, and bear markets are not necessarily the result of recessions. In this article, we will explore the relationship between these two economic events, and how understanding this relationship can help investors navigate the stock market more effectively.
A recession is defined as a decline in economic activity, while a bear market is a period of declining stock prices, defined as a decline of more than 20% from its peak to its lowest point. The relationship between these two economic events is complex and influenced by various macroeconomic and market factors. It’s important to note that recessions do not always lead to bear markets, and bear markets are not necessarily the result of recessions.
When discussing the likelihood of a recession, it’s important to understand the different ways in which a recession can be defined. A technical recession is defined as two consecutive quarters of economic contraction, as measured by a country’s gross domestic product (GDP). On the other hand, official recessions in the United States are determined by the National Bureau of Economic Research (NBER). The NBER considers the depth, spread, and duration of the economic decline, as well as the turning points of various non-fixed weighted macroeconomic indicators. These different definitions explain why technical recessions may not always occur at the same time as official NBER recessions.
Additionally, the strong macroeconomic focus of official recessions means that they are not always accompanied by significant declines in the stock market and vice versa. It’s important for investors to understand these different definitions and how they can impact their investment strategies.
Official NBER Recessions (shaded blue) – Technical Recessions (shaded green) – Both Recessions (shaded red) – S&P 500 Drawdowns (blue line)
The National Bureau of Economic Research (NBER) has recorded a total of 35 recessions in the US since 1854, and by comparing these recessions to the drawdowns of the S&P 500, we can gain insight into how the stock market is affected during these economic downturns. Given the NBER Committee’s exclusive focus on macroeconomic factors means that economic turning points may not always result in corresponding movements in the stock market. More importantly, even severe stock market downturns do not always result in a recession like in 1962, 1966or 1987 where the S&P 500 declined by more than 20%.
Our analysis shows that only in 9 out of the 16 recessions recorded by the NBER, the stock market recorded significant losses of over 20%. However, it’s also important to note that in 12.5% of cases, the S&P 500 even rallied during official NBER recessions, showing little relationship between the market and the underlying economy. Interestingly, in the remaining recessions, the stock market drawdowns, measured by the S&P 500, were relatively moderate in their nature.
That finding shows that it is important to do not equate recessions with bear markets or even stronger declines. Another point to mention here is that, due to the delayed data availability of certain macroeconomic, recessions can only be determined months and sometimes even years in hindsight.
In the end, even if the start- and ending point of a recession could be perfectly predicted, there is still a huge risk that the markets will behave differently than expected. These findings highlight the importance of understanding the relationship between recessions and stock market performance and the need for investors to have a well-defined strategy in place to navigate these economic events effectively.
It is important for investors to have a strict investment plan in place, rather than being swayed by discussions about recession probabilities. While economic recessions can certainly have an impact on investments, it is important to note that not all recessions lead to bear markets and bear markets are not always the direct result of a recession. The relationship between these economic events is complex and influenced by a variety of factors.
By adhering to a well-established investment process, investors can remain focused on identifying potential opportunities and not be distracted by the recession probabilities discussed by financial media. Keeping informed about current market conditions is important, but it is equally crucial to maintain a long-term perspective and not let short-term market fluctuations influence investment decisions.
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