Are Stocks Signaling a Recession?

Not necessarily; market slides don't always mean economic rout. Still, S&P offers defensive strategies—and stock picks—for antsy investors

by Sam Stovall From Standard & Poor's Equity Research

Sector & Subindustry Performance Before and During Recessions

Market Performance Before and During Recessions

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With so much discussion of recession in the markets these days, it's time for a brief refresher about the "R" word. U.S. economic recessions are contractions in growth identified by the Business Cycle Dating Committee of the National Bureau of Economic Research, usually well after the fact. Arthur Okun, an economic adviser to Presidents Kennedy and Johnson, developed the rule of thumb in which two successive quarters of decline in real (inflation-adjusted) gross domestic product signals a recession. (It's only a guide, however, as the recessions of 1981 and 2001 occurred with only one quarter of GDP decline.)

Since 1945, there have been 11 recessions, occurring every 5.5 years on average. The longest stretch between recessions was the 128 months separating the 1990 and 2001 recessions. The shortest was in the early 1980s, with only 18 months between them; some economists say those two were just one long recession separated by a short spate of growth. On average, recessions have lasted a little more than 10 months. Six stuck around 10 months or more, with the two longest occurring in the 1970s and the 1980s.

Since the intrinsic value of stocks is based largely on the underlying growth in corporate earnings, it should come as no surprise that equity investors have historically anticipated the onset of economic slowdowns or contractions. Every recession since World War II was preceded by declines in equity prices that in seven cases became bear markets (a decline of 20% or more), in three cases became contractions (declines of 10%-20%) and only once resulted in a pullback (a 5% to 10% decline). In all, the average sell-off in equity prices before and during recessions saw a decline of 26% in value for the Standard & Poor's 500-stock index.

In addition, more speculative benchmarks, such as the Nasdaq composite index and Russell 2000 index of small companies, also posted price declines ahead of recessions—usually in excess of the declines recorded by the larger-cap indexes. Due to the U.S.'s global influence, the decline in U.S. equity prices during these periods may also have largely influenced the 23% average decline of the MSCI-EAFE's (EFA) (a benchmark of large, global companies in developed nations).

Therefore, the reason investors have such an overwhelming fear of recessions, in our opinion, is the magnitude and frequencies of declines associated with these economic weak spots. What's more, investors have come to learn that during recessions, there are few places to hide.

Rotations and Recessions

An old saying states "There is always a bull market someplace"—either in individual sectors or industries. Does this adage hold true during recessionary periods? Yes, but not for many. S&P introduced its Global Industry Classification System (GICS) in 1994, globally categorizing companies into a consistent number of subindustries at the detailed level and sectors at the summarized level since 1990. Prior to 1990, only subindustry-level data were available (they were then called industry-level data). To see how sectors and subindustries fared during the equity market declines identified in the accompanying table, I computed the price performances for the pre-1990 industries during the eight recessionary periods since 1945 (I had to exclude the 1944 observations for lack of data) and averaged their performances up to the sector level.

After 1990, the subindustry and sector performances were computed using available indexes. I then computed a weighted performance value and frequency of market outperformance for all 10 sectors in the S&P 500 and 36 subindustries that participated in all 10 periods observed. As with all historical comparisons, please bear in mind that what happened in the past does not necessarily hold true for the future.