Are we in a recession? If we are not we will be very soon, according to the latest reports on the health of the economy. As it begins to look more and more as if a recession is inevitable, I thought it would be worthwhile to take a look at the last four U.S. recessions and see how stock prices behaved. But first, a little background on all of the gloom and doom.
The Bad News
Housing prices, the largest single asset for most Americans, fell 11.445 in January according to the Case Schiller Index. This is the steepest decline since they started tracking housing prices in January of 1987, 21 years ago.
Factory activity is down, as is the Conference Board's Index of Leading Economic Indicators. The only thing up is short-term bond prices and unemployment claims.
The consumer confidence index fell to a 15-year low, and their expectations going forward are the lowest since the Watergate crisis and oil embargo. It is a perfect storm for the U.S. economy, and I can find no signs of near-term improvement. We got so used to using our homes as a giant ATM machine to fuel our overspending that the drop in housing prices has left us stunned.
A recession is officially defined as two quarters of negative GDP growth. We have not had that yet, but I suspect the first quarter of 2008 will be the quarter that sets up the recession.
Two Untruths
As to stocks prices, there are all kinds of myths about stock prices in a recession, so I wanted to see how prices did, in fact, react. What I found surprised me and challenged more than one Wall Street adage.
The first misperception I discovered was that stock prices fell before a recession. In fact, this was not really true. In the three months prior to the last four recessions, three out of four times, stock prices were rising. Only in the last recession, from March to November of 2001, did stock prices fall prior to the recession. All the others, January to July of 1980, July 1981 to November 1982 and July 1990 to March 1991, had stock prices moving higher leading up to the start of the decline in economic activity.
Another saying that Wall Street loves is that stock prices often go up over the course of a recession. This, to my surprise, turned out to be mostly true. Again, three out of four times, stock prices rose. The 1980 recession showed stock gains of 14% from start to finish, the '81-'82 downturn had a stock increase of 6.1%; the 1990 recession showed market gains of 5.35 from the start to the end. Again, only the 2001 recession bucked the trend with losses of 9.8%.
Recession Trading
But -- and on Wall Street, there is always a but -- a closer look at each recession showed that perhaps the actual picture was not always that rosy. In the 1980 recession, from the market high of the first month to the bottom of the downturn was nearly 20%. The low of the market took three months to occur before prices began to recover. Prices reached the opening price of the starting month right away and closed at or above that level every month of the recession. All in all, the market reaction to a weak economy was fairly mild.
In the 1981 recession, the high to low drop was right at 23%. It took 14 months for prices to recover to the first-month market high. In addition, it took 11 months for prices to recover to the opening price of the official start of the recession.
The 1990 recession had a 21% high to low drop. Prices reached the opening-month high the second month and surpassed it. After that, however, the market fell for the next three months, and it took eight more months to get back to the first-month highs. In addition, after the first-month rally, and the subsequent fall, it took nine months to get back to opening levels.
The 2001 recession has been the granddaddy of the last four. The drop from the first-month high to its lows was 26%, and it took three years and four months to get back to those highs. The total drawdown before it returned to new highs was over almost 40%. Even though the actual recession ended in six months, prices dropped for much longer than that before bottoming. It also took three years and six months to return to the opening prices of the first month of the official recessionary period.
Where does this leave us right now? Even if we expect prices to be higher by the time this recession ends, the price action could be quite volatile and drop substantially before recovering. The average decline from high to low of a recession was 22.5%.
If we entered a recession in February of this year, as many think we may have, the high was 1396. This would give us a downside to about 1081.9 on the S&P 500. On average it takes about 10 months to recover to the old highs and about the same to recover to the opening price levels. That would take us out to November before it would be reasonable to anticipate a new bull market.
Wall Street adages are nice. Numbers are better. Without a substantial turnaround in the United States economy, a recession is, I think, pretty much inevitable. Once we enter one, it is reasonable based on historic stock market reactions to expect prices to have sharp moves down before recovering. This time may be different. But I do not think that would be the way to bet it.
At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.
