Recessions and Bear Markets: A History of Inconsistencies

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
February 21, 2008

One of my favorite Wall Street anecdotes is: "The stock market has predicted nine of the last five recessions." That's not to suggest the market has failed as an economic indicator—quite the contrary. The stock market remains one of the best leading indicators of the economy (in both directions). And during those periods the market has been weak in anticipation of a recession that doesn't arrive, it is quick to reverse course. Look no further than the business of forecasting and/or declaring recessions to understand why economics is considered such an imprecise science.

With only two exceptions, no academic economists forecasted the crash of 1929 or the subsequent Great Depression. The two exceptions were Nobel Laureate Friedrich von Hayek and Ludwig von Mises, both Austrians. Are we on to something here? Should all economists add a "von" in between their names and move to Austria to improve their forecasting records?

Seven decades have passed since then and ushered in vastly improved tools and information access. Surely we must know more today? You'd be surprised. The study of economic and market cycles … and the relationship between the two … is fascinating. It also highlights just how often conventional wisdom and seeming logic defies the trends—and how difficult the job of forecasting is.

Let's get the definition straight first!
One example of conventional wisdom surrounds the actual definition of a recession. Many, including noted economists, look for two back-to-back quarters of negative gross domestic product (GDP) growth to define a recession. It's odd that this is the accepted definition, when in fact it is not accurate.

The National Bureau of Economic Research (NBER) is the official arbiter of recessions, and a simple query on their Web site shows that the actual definition is a little more complicated. 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."

Inconsistencies
We've had recessions without back-to-back negative GDP quarters (1960 and 2001); and we've had back-to-back negative GDP quarters that have not been declared recessions (1947). Finally, every recession in history, with the exception of 1969, was declared as starting in advance of GDP actually turning down.

The economic indicators themselves can also be inconsistent and misleading. Some recessions are accompanied by plunging consumer confidence (1981), but some see confidence remain stable (1974). Some recessions are driven by—and exacerbate—housing downturns (today, if we have one), yet some see housing remain healthy (2001). Some recessions bring plunging employment (1990), yet some are accompanied by rising employment (1973 and 1980).

In turn, the market behaves differently around each recession. 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 corrections. Regardless of magnitude of accompanying market decline, the majority of the corrections and/or bear markets began in advance of, or early in, each recession.

S&P 500 Performance Around Recessions and Soft Landings

Recession Dates	Bear Market/ Correction	Bear Market/ Correction Dates	Soft Landing Dates	Soft Landing Rally	Soft Landing Rally Dates	S&P 500 P/E
11/48-10/49	– 21%	6/48-6/49				10
7/53-5/54	– 15%	1/53-9/53				11
8/57-4/58	– 22%	8/56-10/57				14
4/60-2/61	– 14%	8/59-10/60				18
			1/67-12/67	21%	1/67-9/67	15
12/69-11/70	– 36%	11/68-5/70				18
11/73-3/75	– 48%	1/73-10/74				18
1/80-7/80	– 17%	2/80-3/80				8
7/81-11/82	– 27%	11/80-8/82				9
			7/84-12/86	72%	7/84-12/86	10
7/90-3/91	– 20%	7/90-10/90				17
			1/95-12/95	35%	1/95-12/95	15
3/01-11/01	– 49%	3/00-10/02				28

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. Per ISI Group, a soft landing is a midcycle slowdown that doesn't lead to a recession. Price-earnings ratios (P/Es) (based on trailing 12-month as-reported earnings) are month prior to start of bear market/correction or soft landing. Sources: Bloomberg, ISI Group, NBER, Ned Davis Research, Inc. and Standard & Poor's.

Also highlighted in the table is the fact that soft landings (we've had three during this same span) have not only kept a bear market at bay, they've been accompanied by very strong stock markets.

Another inconsistency is market valuation around recessions/bear markets. Conventional wisdom might suggest a "cheap" market can keep the bear in hibernation, but as you can see we've had bear markets start with the S&P 500 P/E at or below 10 and the range spans from 8 (1980) all the way to 28 (2000).

Shorter recessions, longer expansions
A comforting trend in modern times is that 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.

There are several likely contributors to these trends. The services sector is a growing piece of the economic pie and employment among those industries tends to be more stable than in manufacturing. As the more stable industries grow in importance, the entire economy by default becomes more stable and less susceptible to either severe or prolonged recessions.

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.

Pattern consistencies
Where there does appear to be more consistency is with 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 has typically peaked about seven months before the recession begins, but bottoms quite decisively by about six months into the recession, with an average peak-to-trough decline of just under 25%.

S&P 500 Performance Pattern Around Recessions

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

In fact, some of the best bear market bottoms and/or historic buying opportunities have come during the depths of recessions. 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 % 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.

Why so hard to forecast?
Given the tendency for the stock market to give a good heads-up on the state of the economy, knowledge of the definition's components, and extensive and widely used economic models, why is it so difficult to forecast recessions in advance? Some of it is situational bias—we tend to extrapolate the good times out further than they're sustainable while doing the opposite at recession-to-recovery turning points. Even the NBER, the anointed recession declaration bureau, has dated recessions well after they've started, and in the past two instances, after their conclusions!

NBER and Economists Typically Lag/Miss by a Wide Margin

Recessions	NBER's Announcement Date of Recession	"The Miss" (Lag)	Consensus GDP Forecast Just Prior to Recession*	GDP Growth in Recession Year	"The Miss" (Difference)
11/73-3/75	NA	NA	3.1%	– 0.4%	– 3.5%
1/80-7/80	6/30/80	5 months	1.4%	– 1.1%	– 2.5%
7/81-11/82	1/6/82	6 months	3.2%	– 1.9%	– 5.1%
7/90-3/91	4/25/91	9 months	2.3%	– 0.2%	– 2.5%
3/01-11/01	11/26/01	8 months	3.1%	– 0.8%	– 2.3%
Average		7 months	2.6%	– 0.6%	– 3.2%
Now/Soon?	?	?	2.0%	?	?

*Full-year GDP growth forecasts in December prior to recessions. Sources: BCA Research, Blue chip Consensus, Merrill Lynch, NBER and the Philly Fed Livingston Survey.

As the table above also shows, economists (in the aggregate) have a terrible track record forecasting recessions, typically having relatively healthy positive GDP forecasts on the record just as recessions are coming.

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, 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.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The 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 here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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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