Putting the Recession and the Stock Market in Historical Context

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Updated October 30, 2008

We have always reminded investors that the stock market is one of the better economic forecasting "tools" there is—with a track record of anticipating economic turns in both directions, that beats the vast majority of actual economists. I'm long on record believing we've been in a recession since late last year, but recently it's become a more consensus view, the absence of a recession's official declaration notwithstanding.

If you're using the stock market as a guide, there's no question we're in a recession. Since the market's top in October of 2007, the S&P 500® is down 36%, which is more than the post-World War II bear market average—but not by much. Since we have yet to see any sign the market is signaling an upcoming economic turn, it's still a safe bet that this recession will be longer than the norm.

I've written about this before. In fact, this report is a newly edited version of my Recessions and Bear Markets: A History of Inconsistencies report. But these times suggest an update is in order to help put some historical meat on the current sordid state of market and economic affairs.

Let's get the definition of recessions straight first
Why can I be so convinced we're in a recession when gross domestic product (GDP) has remained positive? Indeed many, including noted economists, look for two back-to-back quarters of negative GDP growth to define a recession. It's odd that this is the accepted or "traditional" definition, when in fact it is not accurate.

The National Bureau of Economic Research (NBER) is the official arbiter of recessions. They are notoriously late in declaring both recessions' start dates (typically with about a seven-month lag) and recessions' end dates (typically with about a 15-month lag). Part of the problem is that recessions have multiple metrics, all of which are subject to revision. The NBER defines a recession as "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."

With the exception of real GDP, the other four metrics above are well in recession territory, employment decidedly so. And, the only reason real GDP has remained positive is due to a statistical quirk in calculating the deflator (subtracted from nominal GDP to get real GDP). That statistical quirk involves subtracting import prices from export prices. Our biggest import is oil, and it had its biggest jump in the second quarter, artificially lowering the deflator and in turn artificially raising real GDP.

Looking ahead, given the dramatic drop in oil prices during the third quarter, we might see the opposite effect on real GDP—a higher deflator being subtracted and therefore a much lower real GDP being reported. The upcoming third quarter headline for GDP may actually more closely match the angst the average American is feeling.

Market behavior around recessions
The market behaves differently around each recession, but there are some notable similarities. As you can see in the table below, of the 10 recessions we've endured since the end of World War II, seven have been accompanied by bear markets, while the other three have brought less-severe, but still double-digit corrections. Regardless of the magnitude of the accompanying market decline, the majority of the corrections and/or bear markets began in advance of, or early in, each recession. Our current market's peak last October fits squarely in this historical mold.

S&P 500 Performance Around Recessions

Recession Dates	Bear Market/Correction	Bear Market/Correction Dates
11/48– 10/49	-21%	6/48-6/49
7/53-5/54	-15%	1/53-9/53
8/57-4/58	-22%	8/56-10/57
4/60-2/61	-14%	8/59-10/60
12/69-11/70	-36%	11/68-5/70
11/73-3/75	-48%	1/73-10/74
1/80-7/80	-17%	2/80-3/80
7/81-11/82	-27%	11/80-8/82
7/90-3/91	-20%	7/90-10/90
3/01-11/01	-49%	3/00-10/02
??	-46%	10/07-present¹

1. As of October 27, 2008. Bear market = 20% or more drop in S&P 500. Correction = 10% to 20% drop in S&P 500. Bear market/correction occurred anytime 1-year prior to recession start through 1-year following recession end Sources: Bloomberg, NBER, and Ned Davis Research, Inc.

Shorter recessions, longer expansions
In modern times, recessions have been getting shorter while expansions have been getting longer. The average recession since World War II lasted 10 months, while the average length was more than twice that in the nineteenth century. Conversely, the average expansion since World War II lasted twice as long as those in the nineteenth century. Unfortunately, today's recession is likely to be a doozy, both in duration and magnitude terms.

In addition, the government and the Federal Reserve have been playing more significant roles in moderating recessions, especially since the Great Depression in the 1930s. Unemployment insurance has helped to reduce the loss of income during recessions while monetary policy has been used more effectively to lower borrowing costs and increase credit availability. I won't use this space to illustrate what's been done to date by the Fed and the Treasury Department because we have reams of reports on that currently posted on Schwab.com. Suffice it to say today's interventions have been truly unprecedented.

Pattern consistencies
There is a lot of historical consistency in terms of the pattern of returns for the market around recessions, if not the magnitude. As you can see in the chart below, which combines all of the 10 prior recessions into a single average line, the market typically peaked about seven months before the recession began, but bottomed quite decisively by about six months into (or 60% of the way through) the recession, with an average peak-to-trough decline of just under 25%.

S&P 500 Performance Pattern Around Recessions

S&P 500 Performance Pattern Around Recessions

Indexed price-only data from 1947-March 31, 2002. Source: Ned Davis Research, Inc.

In fact, history has shown some of the deepest bear market bottoms and/or buying opportunities have come during the depths of recessions. The S&P 500 is currently down 36% peak-to-current, so we're clearly beyond the historical norm. Since it's anybody's guess as to when the market will bottom, this may be the market's way of telling us this recession is likely to be a tougher one than usual.

But let's not forget that historically, a significant percentage of bear market finales have occurred during economic recessions. In fact, six of the nine last bear markets ended during recessions. And the subsequent rallies/new bull markets can be fierce and quite rewarding … that's assuming you haven't fully bailed out of stocks during the pain on the downside.

Note in the table below the performance averages for the market during various periods following stock market troughs in recessions.

S&P 500 Performance Following Recession Lows

	S&P 500 Percentage Gain
S&P 500 Low Date in Recession	3-Months Later	6-Months Later	9-Months Later	1-Year Later
06/13/49	15%	19%	27%	34%
09/14/53	10%	18%	28%	39%
10/22/57	6%	10%	19%	32%
10/25/60	16%	25%	28%	31%
05/26/70	17%	21%	39%	45%
10/03/74	14%	30%	52%	35%
03/27/80	18%	31%	39%	37%
08/12/82	38%	42%	61%	58%
10/11/90	7%	29%	29%	29%
09/21/01	18%	17%	3%	-14%
Mean	16%	24%	32%	32%
Median	15%	23%	28%	34%

Source: Ned Davis Research, Inc.

Nobel Laureate Robert Solow once said: "It is acutely uncomfortable to have so much in macroeconomics depend on how one deals with a concept like expectations, for which there is (inevitably?) so little empirical understanding and so much room for invention." However, uncertainty is not only normal, but pervasive, in the economy and markets. As such, future expectations become a critical variable in most decisions (economic or investment).

Most stock market observers are aware of the sentiment effect—peak levels of optimism are often followed by corrections and vice versa. Much is the same with economic cycles: The economy typically falls into recessions not because of random shocks or crises, but because extreme optimism and euphoria is replaced by extreme pessimism and despair. Today's recession is a function of both: a crisis that continues to exacerbate what was already a feeling of despair. But the key is not letting your despair cause you to panic.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Any investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and are not intended to imply future results.

Past performance is no guarantee of future results.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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