How does the market respond to a recession?

What happens in stock markets during a recession? Stocks can also grow when the economy shrinks: Although falling markets sometimes coincide with recessions, stocks have actually produced positive returns in seven of the 13 recessions since 1945. In fact, the S&P 500 index has increased by an average of 3.68% during each historical recession.

Data sources: Morningstar, Ned Davis Research and Hartford Funds

During the recent recession from February 2020 to April 2020 caused by the pandemic lockdowns, stocks fell 1.4%, but the S&P 500 closed the year with a gain of over 16%. During the financial crisis of 2008, a longer downturn, stocks had fallen nearly 40% that year before rebounding 23% in 2009.

Markets typically bottom and recover months before a recession ends. Source: CFRA Research, NBER, S&P Global

Which direction we are going? The multidimensional situation, which can be described as a recession of a type that has never been seen before, leads to not being very optimistic for the upcoming period. The approaching recession risks hitting hardest for the following reasons:

 Extremely high asset valuations

The Shiller P/E Ratio was created by economist Robert Shiller and is calculated by dividing the price of the S&P 500 by the average of inflation-adjusted earnings over the last 10 years. It seeks to smooth the cyclicality of earnings. Historically, high Shiller P/E Ratios have led to below-average long-term returns.

Shiller P/E ratio historical development… Source: https://www.multpl.com/

·        Weak economic fundamentals

The US economy is not as strong as it used to be. While this may seem like a situation after the Covid pandemic, it is actually a weakness that has also emerged in cycles of economic crisis over the past two decades. All the taxes, regulations and other government interventions into the economy in recent years have created a weaker and more fragile economy that will only worsen the next recession.

The Industrial Production graph below is just 8% higher than the 2000 peak and 1% lower than the 2007 peak. In the last two decades it has almost flattened out. This marks a much weaker trend than the 3.9% annual growth in Industrial Production from 1920 to 2000.

Historical development of industrial production index… Source: St. Louis Fed FRED

 Excessive debt levels

Excessive debt burden has been a problem in every financial crisis in history. Given these unprecedentedly high debt levels, debt liquidation and defaults will lead to deflation, especially for asset prices, as we saw in the Great Recession and even the Great Depression.

The chart below shows the US Federal Debt to GDP Ratio at 125%, close to all-time highs.

US Federal Debt to GDP ratio… Source: St. Louis Fed FRED

 Limited policy options

Overprinted money does not create new goods and services that improve living standards. If it were, a place like Zimbabwe would be the richest country in the world. However, newly created money can flow into financial assets, which helps explain why valuation levels are so high.

As the chart shows, the Fed has lowered interest rates during the previous three recessions. As of last week, the Fed has increased interest rates by another 75 basis points, and Chairman Powell has announced that they may continue to raise rates at these levels. This had a positive impact on the market as the Fed is expected to raise rates between 75 and 100 bps and the Fed will likely cut interest rates in the coming quarters.

Federal funding effective rate… Source: Federal Reserve, FRED

Conclusion? It looks like the impending recession could be one of the toughest living. There may be some serious downturns between the vast majority of companies in the S&P500 and overall equity markets in the coming quarter as well. However, the stock’s poor performances mean a cheaper price per share. This means that for the investor, good entry points can be found with the potential for huge price increases over the broad term. A fall in the share price does not mean that a company will go bankrupt. In a macroeconomic recession environment, it is normal for companies to underperform compared to periods of precautionary measures that give the economy high liquidity. As we can see, the market always recovers after big dips, which actually creates good opportunities and nice entry points to invest.

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