11Feb2016
Can the Market Predict Recessions?
by Bryan Ward, CFP®, CIMA® in Economic Updates, International Markets, Investments, Risk Management

The start of 2016 has brought with it a strong sell off in the stock market. With the S&P 500 being down 9.5% for the year and down over 13% from its peak back in May of 2015, the hot topic of discussion other than from Donald Trump has been of the likelihood of a U.S. recession.

  • Deteriorating economic conditions in China
  • Global recession concerns from low Oil prices
  • European Bank concerns and Sovereign debt fears
  • Rising strength of the dollar

While all these issues make for good headlines and TV chatter, it is unclear what it means for the U.S economy. Primarily because a number of important economic indicators in which the National Bureau of Economic Research (NBER) committee consider before announcing a recession are not necessarily telling us to run for the hills just yet.

Employment is growing. Although the upward trajectory is not as great as many would hope.

Retail Sales & Credit conditions flattened a little in 2015, but still grew slightly.

Interest Rates continue to be near record lows. The Fed initiated the first rate hike in years, but is continuing to be cautious on future hikes.


Ycharts.com

Industrial Production which has been a driving force in the recovery from the financial crisis of 2008 is one area that has seen weaker numbers in back-to-back months. Weakening demand from several industrial sectors affected by declining commodities prices such as oil and gas, mining, and agriculture, as well as slowing demand from China; have all been contributing factors to the slump in manufacturing. The concern is that the slowing demand will lead companies to postpone investment and shift into cost-cutting mode leading the way for an industrial recession. Some may say companies are better positioned to weather such a storm. But how big of a storm and for how long is the unknown.

This brings me to the question. Are we able to use the stock market as an indicator to recession? Does a recession lead to a decline in the market, or does a market decline foreshadow a recession?


Ycharts.com

In the past five recessions since 1980, three of the recessions saw the index higher at the end of the recession than the start. Not charted in this chart, since the 1957, the S&P 500 has always peaked before the peak of a business cycle, with one exception (1980 business cycle)(1) . The S&P 500 has established a trough prior to the end of a recession without exception. In most cycles, the index peaked long before the recession start and bottomed before the end. (1)

So perhaps we can conclude that this current market weakness is foreshadowing a recession if it peaks almost always before a business cycle. But wait, does a “bear market” (a decline of 20% or more) always coincide with a recession or does a recession always determine a bear market?

The following chart below shows the S&P 500 levels from off its highs going back to 1980. And we can see that even in that period we experienced a bear market in 1988 without a recession and the 1990-91 recession without technically a bear market (although close). If we go back to 1957 at the start of the S&P 500, we can chart 3 bear markets that did not coincide with recessions as well as 3 Recessions that did not result in bear markets.

Ycharts.com

Finally I wanted to get a better understanding of the timing of when the market dropped and the timing of the recessions. The chart below lays out the days between when the recessions started and when the NBER actually announced we were in a recession. I also list how far the S&P fell between its prior peak and the start of the recession. (1)


Data from NBER.org and Ycharts.com

Thoughts….

Each recession is different and the economic data that is used to determine a recession is drawn over a period of several months as shown in the chart above. The market on the other reacts immediately to every little bit of news that we obtain on an hourly basis. It is because of how quickly the news and market reacts that we will continue to see the market drop from their peaks before any announcement of a recession just as we will see them rebound prior to the end of a recession.

One thing I can conclude is that we will have more recession in the future. But the data varies too much to connect a relationship between the market and recessions that trying to use the market as a gauge for timing or determining how big or long of a recession is a fool’s game and should not be used as a way to base your investment decisions.

The opinions expressed herein are those of the author. Such information is subject to change and is not intended to influence your investment decisions.

1. Historical data acquired from ycharts.com, NBER.org and Standard and Poor’s

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