The watchword of late in financial news: Recession! Pundits speculate about whether one is imminent and what investors should do about it. To help you sort through these headlines and filter out the noise, here is a handy primer on recessions and what they mean for stocks.
A recession is a broad, sustained decline in national economic activity—simple enough in theory. Measurement, though, is tricky. One popular approach says a recession is two or more consecutive quarters of falling GDP. But for the official arbiters of recessions like the National Bureau of Economic Research (NBER) in the US, it is a little more nuanced. NBER calls a recession “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.” This is how the US got a recession in 2001 despite not having two straight quarters of falling GDP.
We think this is a matter of semantics, not substance. These terms arise from the popular fixation on the “two straight quarters of contraction” measurement. Which, sure, it is possible for data points like manufacturing output, housing sales or energy investment to fall for consecutive quarters. But in our view, “recession” is the wrong term here, since it refers to total economic activity, not this or that subcategory. For specific industries, we think “soft patch,” “weak spell,” “pullback” and the like are better terms.
Definitions first: A bear market is a prolonged, fundamentally driven stock market decline of -20% or greater—not to be confused with a correction, which is a sentiment-driven decline of -10% or more. Now, back to the question: Yes, recessions can cause bear markets—but there are some caveats.
First, markets lead the economy, not the reverse. Hence, a bear market will often begin as stocks gradually discount the rising likelihood of a recession. In this way, the approaching recession caused the bear. This also means a recession’s start isn’t a market timing tool. By the time it begins, stocks are usually well into a bear market—which, in turn, typically ends well before the recession does.
Because stocks generally bounce back sharply following a bear market—forming a V shape—stocks often rise overall in recessions. Some cite this to argue recessions aren’t so bad for markets after all. This is a fallacy—the fact markets start looking ahead to better times before data capture an improving economic picture doesn’t mean the (approaching) downturn didn’t cause the bear. In a new bull market, this disconnect also creates confusion. While they are ongoing, pessimistic investors commonly view them as illusory bear bounces since economic data have yet to turn positive.
Other things can cause bear markets, too—which helps explain why 1987’s didn’t have a corresponding recession. Similarly, the bear market beginning in March 2000—over nine months before the recession officially started—was more about the bursting of the Tech bubble.
Maybe, if you see something no one else does that has a high probability of subtracting a few trillion dollars from global GDP. But this is easier said than done, in our view. One reason: Widely discussed negatives don’t qualify. Efficient markets price in all public information—plus interpretations thereof, including forecasts. So if you see a huge danger looming, ask: What are other people saying about this, if anything? Is it dominating headlines? If so, it probably won’t spur a bear market. As Fisher Investments founder & Executive Chairman Ken Fisher likes to observe, if pundits are talking a scary story to death, you ought to send them a thank you note for depriving that scary story of the surprise power necessary to potentially trigger a bear market.
Not necessarily. Given spending on highly discretionary products and services—like expensive durable goods and some luxuries—tends to fall in a recession, many consider declines in big ticket discretionary purchases, tourism and eating out as harbingers of recession. Many of these things could indicate a downturn in progress. But they aren’t sufficient to identify a recession—especially not if just one or two data points are faltering.
In theory, perhaps, but in practice we think this is extremely unlikely. People wrongly view consumer spending as the economic swing factor, as it constitutes the lion’s share of developed world GDP. But most spending goes toward services. Demand for these is generally inelastic, meaning it doesn’t fluctuate with economic conditions. Only a small portion of consumer spending is discretionary—which helps explain why consumer spending never fell in the 2001 recession. The real swing factor, in our view, is business investment. While big contractions don’t necessarily presage recession, they frequently accompany recessions as firms scale back expansion plans and/or cancel investments in order to cut costs and survive. This downshifting is also visible in large inventory cuts, though these are always open to interpretation. Slashed inventory can signal firms anticipate tough times ahead, it might also indicate they are rushing goods out the door to meet strong customer demand. So, a grain of salt there.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.