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Recessions are arguably the largest risks to the market because they cause the largest drawdowns in stocks. They’re often accompanied by general deleveraging, a run on a bank, a large change in investor sentiment, a low probability black swan event, or a combination of all of those.
Yet, many Wall Street analysts spend little time understanding recessions and what they bring. So I rolled up my sleeves and took a deep dive into recessions, their lengths, market performance, and how to use history to predict where we currently are in the economic cycle. The goal: To show whether or not recession risk is a real threat today.
Here’s a chart of the stock market data going back to 1870. S&P data was available back to the 1950s, but prior, we used reconstructed data courtesy of Nobel Laureate Robert Shiller. Recessions, as depicted by the National Bureau of Economic Research (NBER), are the light grey time periods. The S&P data started below 10 back in the late 1800s, but is now well over 2,000. So to illustrate things more clearly, we used a log transformation of the data, which highlights relatively minuscule values in the early years.
If you look at the shaded areas and notice the performance of the stock market during those periods, you’ll see the declines in the stock market were the greatest. Or in other words, recessions were times when the market fared its worst.
The market declined 52.6% (on a monthly basis) during the 2008 Great Recession, and more than 31% in the 2001 Tech Wreck. Those are just drawdowns during recessions from pre-recession highs, too. In some cases, markets continued to decline after the recessions were officially “over.”
For instance, the 2001 Tech Wreck gave way to an additional 12% decline before markets recovered. Even though we were on better economic footing after the recession, investors still weren’t confident with valuations given how far we had gotten ahead of ourselves before the recession.
Conversely, the market certainly had its best returns during expansionary periods:
Here’s something else interesting in the data: The average period of expansion was 41 months, and expansionary periods are becoming longer in recent years versus history. That’s important because recessions are becoming less frequent and seem to be defying historical odds.
So far in our recent expansion, we’re at 7.6 years. That makes this the third-longest boom, behind the 1960-1970 and 1990-2001 expansions. That doesn’t mean it is going to end -just that historically speaking, we’re not in the early legs of the expansion.
Here’s something else to consider: Contractions are much shorter in duration, lasting on average just 16 months. But they’re responsible for the largest declines. It’s true, as the old saying goes: Markets take the escalator higher (denoting a grind higher over a long period of time), and then the elevator lower (crashes happen over shorter periods of time).
That brings me to the most important point for investors in smaller capitalization stocks: As of right now, the economy is on very sure footing, with job creation high, manufacturing and services sectors picking up, interest rates rising, and more. Even though stocks are up 147% since the end of the last recession 7.6 years ago, we still have room to run.
After all, we’re still shy of the longest expansionary period since 1870, the 10-year run between 1990-2001. Markets more than tripled during that stretch, rising 209%. And with the catalysts this market has in front of it — like less taxation and less regulation — that trend could continue. I wouldn’t be surprised if we reach new records in terms of length of the current expansion and the market returns it brings.
Soon, I’ll show you how to profit from that using small cap stocks – so stay tuned!
Best,
Mandeep
Small Cap Edition, By Mandeep Rai, Senior Analyst Mandeep Rai has more than 15 years of investing experience, working as both a stock and credit analyst. At Weiss Ratings, he researches and evaluates financial and economic themes, and makes decisions on when to buy or sell specific shares for the Top Stocks Under $10 portfolio. |
