How Bearish Does The Stock Market Get During a Recession? 28% Down…or Growling in Bearishness
Nouriel Roubini | Sep 05, 2006
How sharply will the US stock market fall if my recession call ends up being correct? Given the recent flow of macro news, the likelihood of a US hard landing has certainly increased; thus, it is important to assess the implication of such growth slowdown, hard landing or outright recession on the stock market.
As I predicted at the time of my recession call, the Fed decision to pause and then stop would lead to a suckers’ rally. This typical suckers' rally always occurs at the beginning of an economic slowdown that leads to recession. The first reaction of markets to such bad economic news is usually a stock market rally based on the belief that a Fed pause and then possibly easing will rescue the economy. This is always a suckers' rally as, over time, the perceived beneficial effects of a Fed ease meet the reality of the investors realizing that a recession is coming and that the effects of such a recession on profits and earnings are first order while the effects of the Fed easing on the economy and stock market are - in the short run of a recession - only second order. That is why you can expect another suckers' in early fall when the Fed will actually reduce the Fed Funds rate. But, as the continued flow of poor macro news increases the probability of a recession, the equity markets will - in due time – sharply fall when wave of news and macro developments hits hard a weakened and vulnerable economy; then you will see a serious bearish market in equities.
Actually, the initial equity market response to the August 8th FOMC statement was tentative as the statement was interpreted by the markets as suggesting that maybe the Fed was not done yet and that further hikes in the fall could not be ruled out. I had then predicted – even before the August 8th statement - that the then almost sure Fed pause was actually a stop and that the next Fed move would be a cut – not a hike – in the fall or winter. Markets were behind the curve in realizing the downside risks to growth and were still debating whether the “temporary” Fed pause would be followed by a hike. It then took the mild PPI and CPI reports to radically shift the market consensus from the view that the pause was temporary before another hike to the view that the pause was actually a full stop with some possibility – still in a minority view – of a Fed Funds cut in late 2006 or 2007. It was then – when the consensus moved from pause-to-hike to pause-to-stop – that the stock market has its true post-FOMC suckers’ rally as the market finally expressed relief to the news that a full stop was not more likely. You may indeed see another suckers’ rally when – following even more bad macro growth news – the consensus will move towards a higher probability of a Fed Funds cut – rather than just a protracted pause.
It is well known – from basic macro theory – that the equity market reaction to poor growth news is ambiguous. Lower than expected growth lead to a higher stock market value via the “interest rate channel” and to a lower stock market value via the “profits/earnings channel”. The former effect derives from the fact that bad economic news increase the probability that the Fed will ease monetary policy and thus stimulate the economy, demand and profits. The latter channel derives from the fact that slower growth – or even worse an outright recession – will lead to lower demand, lower revenues and lower profits. Indeed, as stock prices are forwards looking and equal to the discounted value of dividends where the discount rate is related to an appropriate measure of interest rates, bad growth news affect the numerator and denominator of the ratio of dividends to the appropriate discount rate. Usually, the first effect dominates at the beginning of an economic slowdown – when the likelihood of a slowdown is high but the likelihood of a true hard landing or recession is still low and unclear: then the interest rate channel dominates the profits channel. But once the signal of a hard landing or recession become clearer and the likelihood of such hard landing much higher the profits channel dominates the interest rate channel.
Why is this conceptual discussion important? Now that the likelihood of a hard landing or even a recession has increased – even in the eyes of otherwise perma-bulls – one is starting to hear and read with increasing frequency some Goldilocks statements such as “a hard landing will be good for stocks” or “the stock market will rally during a recession” or “the Fed will rescue the markets during a recessionary hard landing”.
For example the WSJ recently was reporting the following:
Widely followed Wall Street economists were telling clients that even a significant economic weakening might actually be good for stocks.
"If we could have a hard landing but not a recession, I think that would be a favorable outcome for the financial markets," says economist Ed Hyman of New York research and brokerage house International Strategy & Investment. Should the Fed start to worry that it has slowed the economy too much, Mr. Hyman says, then it would have to cut rates sharply. Investors would welcome the rate decline as a boost to growth, consumer spending, the housing market and profits.
"History tells me that a significant weakening in the economy and a crisis-induced reversal of Fed policy could make this stock market move up dramatically," he says.
While the well-respected Hyman made a distinction between a “hard landing” and a “recession” and argued that a hard landing could be good for stocks, it is not clear what he means with a hard landing? A slowdown to of growth to 2.5% or 2% or 1%? The fuzziness of his remark hides the typical market perspective that a sharp economic slowdown, short of a recession, could actually be good for the stock market.
To clear the air from the spin that one is increasingly hearing it is useful to ask a simple factual question: what is the relation between stock markets and recessions? So, for a moment, let us leave aside the issue of whether my recession call is correct or not. And let us assume, for the sake of the pure logical argument, that a recession is coming and then ask the question: if we will have a recession, what will happen to the stock market? So, you do not have to believe in a recessionary hard landing to consider this specific question. You just need to ask yourself the simple question of what happens to stock prices when recessions do come. (Thus, for now I will aside the question of what happens to the stock market when you get a “soft landing” or “hard landing” short of a recession. I will consider this question in a future discussion)
Luckily we have enough data series on previous recession and stock prices to give an answer to this question. Consider the charts that are shown below. They present the percentage change in that S&P500 index around the last six U.S. recessions (i.e. starting with 1970), i.e. in the months before the start of a recession, in the months during a recession and in the months after it. The vertical lines in each charts represents the peak of the business cycle (i.e. the beginning of a recession) and its trough (end of a recession). On average the stock market does not change much between the peak and the trough of the business cycle: on average the fall is only 0.4% between peak and trough; in some recessions – such as the 1974-1975 one - the peak-to-trough fall is much deeper (-13%) but in others – such as the 1980 one – stock prices actually rose 5.8% between peak and trough; so -0.4% is an average for all recessions.
This may seem like a relatively small adjustment but the peak-to-trough comparison is deceptive. It is deceptive because, usually, the stock market starts to fall before a recession starts (i.e. before the business cycle peak), then it falls very sharply during the first stage of a recession, and then in starts to recover in the late stages of a recession before the recession has reached its bottom (i.e. before the trough of the recession). Specifically, the stock market falls from the peak in the business cycle to its lowest level during a recession averages 17.5%; and in every one of these six recessions you have the same pattern: initially stock prices sharply fall as the economy enters a recession. Then, the recovery of the stock market starts before the trough of the business cycle has occurred, i.e. before the economy has gotten out of a recession.
Notice also that, in most episodes, the stock market peaks a few months before the actual start of the recession and starts falling even before the formal start of the recession (i.e. before the peak of the business cycle). Since stock prices almost always start to fall a few months before the recession has formally started – as signals of an impending slowdown and possible recession are already mounting even before a recession is formally triggered and thus priced in the stock market – the cumulative fall in stock prices from their pre-recession peak to their bottom level in the actual recession is well above the 17.5% figure for the stock price fall from the start of a recession to the lowest level of such stock prices during a recession. This average fall in stock prices from pre-recession peak to into-recession bottom is actually close to 28%, an extremely severe and sharp bearish downfall.
In other terms, the peak-to-trough average flat behavior of the stock market hides a much sharper fall in the stock market before a recession and during the first half or so of a recession, followed by a relatively sharp recovery in the late stages of a recession. This pattern makes total sense as equity prices are forward looking and, at any point in time, they reflect all available information about the expected path of current and future dividends/earning and interest rates. The stock market starts to fall before a recession has formally started because the closer you get to the peak of the business cycle when the macro news on growth become increasingly weaker, the higher is the probability that a recession will occur and will thus drag down profits. So, a forward looking equity market peaks before the peak of the business cycle and starts falling before the actual recession has started. That is why stock prices tend to be a good – if imperfect - leading indicator of the business cycle.
The fall in the stock market from the peak of the business cycle to the market lowest level in the recession was 21.0% in the 1970 recession, 33.88% in the 1974-75 recession, 10.6% in the 1980 recession, 18.2% in the 1981-82 recession, 14.6% in the 1990 recession, 10.3% in the 2001 recession. In most recession, as discussed above, the stock market peaks before the recession and starts to fall even before the recession has formally started. In the 1970 episode the stock market peaked 9 months before the recession and fell 12% even before the recession started. In the 1974-75 episode, the stock market peaked 12 months before the start of the recession and fell 23% even before the recession formally started in December 1973 with a good half of this pre-recession drop right after the beginning of the Yom Kippur war that led to Arab oil embargo. An exception is the 1980 episode when the stock market was actually rising in the few months before the start of the recession in February 1980. In the 1981-82 case, the stock market peaked four months before the onset of the recession and then fell already about 4% before the recession actually started. In the 1990 case, the stock market peaked two month before the recession and fell about 2% before the formal start of the recession. In the 2001 episode, the S&P peaked about seven months before the start of the recession in March 2001 and then fall by 31% even before the recession started (the peak of the Nasdaq was, of course even earlier, in March 2000 a full year before the formal onset of the recession).
Of course, in the economic history of the US in the last few decades sometimes stock prices have fallen and a recession has not materialized, i.e .stock markets are not a perfect and uniquely correct leading indicator of a recession. But, and this is more important in the context of the question asked above, any time a recession did occur, the stock market actually sharply fell. So, the issue here is not whether the stock market may at times provide false alarms or incorrect signals of the business cycle; of course, as it is well known, it does at times provide false signals. The issue is whether hard landing and beginning of recessions are associated with sharply falling stock prices. And the simple and unequivocal answer is that recession lead to bearish stock markets where the peak in the economy to the trough in the stock market (as separate from the economic peak-to-trough that lags the one of asset prices) is about 17.5% and where the peak-to-trough in the stock market (i.e. the pre-recession peak to the into-recession bottom of the stock market) is about 28%, i.e a very clear, sharp and deep bear market. So, factually hard landings and recessions do lead to falling stock prices and bear stock markets. So, the recent market buzz and chatter about hard landings and recessions being good for the stock market is utter nonsense based on actual data from decades of US business cycles and repeated recession episodes.
Of course, once a recession has triggered a severe bear market, at some point – before the bottom of the recession – the stock market does start to recover. The fact that the stock market recovers before the trough of the business cycle is reach is also logical and based on the forward looking nature of stock prices: even before a recession has ended the rate of economic activity fall tends to increase: in early stage of a recession the first derivative of output is negative (negative growth) while the second derivative shows an acceleration of the rate of economic contraction. In later stages of a recession, the first derivative is still negative but the second derivative shows a slower rate at which the economy is contracting and signals that the trough of the business cycle may be close, i.e. there is incoming light at the end of the recession tunnel. Thus, for forward looking stock prices it is not necessary to wait until the recession is over for such prices to recover: once the evidence is building up that the worst stage of a recession is close to be over and that the trough – bottom of the downturn – will be reached soon (i.e. the probability that the recession will be over soon is increasing) then the stock markets starts to recover: i.e. stock prices reach their trough before the trough of the business cycle.
How about “soft landing” episodes, i.e. episode where a Fed tightening did not lead to an outright recession but rather to a significant slowdown of the economy and then an economic recovery? The only recent episode of a successful soft landing is 1994-95 when a 300bps tightening by the Fed in 1994 did not lead to a recession but rather a relatively sharp slowdown in the economy. Note that, even in that episode, the Fed risked overdoing it and it eased the Fed Funds rate in 1995 when the slowdown appeared as excessive and risking to jeopardize an economic growth that was on the cusp of the internet and information technology revolution of the mid-late 1990s. Note also that, in that episode, the economy was just coming out of a painful recession that, while it formally ended in 1991, was followed by a job-loss and then a job-less recovery in 2002 and 2003; only by early 1994 the economy was showing signs of rapid growth and employment recovery. So, in term of economic cycle, the monetary tightening of 1994-95 was at a very different stage of the business cycle, early-mid recovery and the Fed was just bringing back the Fed Funds rate to a neutral level after its sharp easing during the 1990-91 recession. In terms of the market consequences of such a “soft landing”, the S&P500 fell by 5% between January and December 1994 as the Fed tightening was under way and the economy was starting to decelerate following the monetary break imposed by the Fed. Thus, while the S&P had started to briskly recover after the 1990-91 recession and had double digit return both in 1992-93 and from 1995 on, the soft landing of the economy in 1994 led to a significant fall in the stock market: while the fall in 1994 was modest – about 5% - since the underlying trend in the market index for a sharp double digit annual recovery since 1992 and after 1995, the soft landing of 1994 implied an underperformance of the stock market relative to its underlying trend that was of the order of 17%, i.e. without the soft landing slowdown of 1994 the market could have grown – based on the underlying trend of the S&P – by at least 17%.
What are the potential caveats to the arguments above that a US recession would lead to a sharp drop in the stock market? Some argue that the sharp fall in equity prices during previous recession occurred after long periods in which the market was bullish and sharply increasing; thus, close to a recession P/E ratios were already excessively high and bound to adjust; also the monetary and credit tightening in previous recession squeezed severely profits and push equity prices lower. Instead, it is argued that today’s conditions are very different from previous growth slowdowns: equity prices have zig-zagged without much of a strong trends for the last six years while earnings have sharply increased given increased profitability of the corporate sector; thus, the argument goes, P/E ratios are now relatively low and valuations are not inflated; if anything, given the surge in earnings valuations are relative low and bound to rise if a soft landing occurs or bound not to fall as much even if a hard landing occurs. Specifically, unless a major credit crunch or monetary tightening leads to a sharp fall in profits and earnings, equity valuations may not be as much at risk in a US hard landing scenario.
The above arguments require a whole separate discussion of earnings and profits and their likely future trends that I will undertake in a separate future blog or paper. For now, let me observe why these arguments are not convincing. First, in a recession revenues fall and both profits and earnings sharply fall; so equity valuations need to take a hit; and while recessions triggered by a credit crunch or severe monetary tightening have more severe effects on corporate profits even recessions triggered by the bursting of a bubble – the tech bubble in 2000, the housing bubble today – can severely affect earnings and thus valuations. Second, recent data from the Q2 GDP numbers suggest a very rapid slowdown in real profits in Q2, to something close to 2% in real terms down from a growth rate of 12% in Q1. Thus, profits slowdown is already occurring; and outside the S&P500 firms and outside the energy and financial sectors, Q2 earnings are also already showing serious sluggishness. Third, on a cyclically adjusted basis P/E ratios are still very high: since both profits and earnings now look peaky and bound to sharply slow down, P/Es may be still too high once one considers the likely fall in earnings during a slowdown and/or an outright recession. Of course, the fact that valuations have been relative flat for a number of years may imply that not all stocks will be hit as hard in a recession: many will gradually fall during the economic downturn but others, that have low valuations now and whose earnings would be less affected by a recession, may do relatively better or not as bad as the overall market. Still, it is hard to avoid the conclusion that a recession would be really bad for the stock market. In every previous recession equities have done very poorly and it is hard to make a logical or empirical argument why in the next recession things would be meaningfully different.
Finally, notice that the equity valuations of homebuilders have already followed the pattern that I described above. While the overall economy has not yet fallen into a recession, the housing sector is certainly in a major bust right now; the severe worsening of the housing market has been indeed clear for several months now as sales, profits and earnings have sharply fallen for the Toll Brothers, many other producers of McMansions and homebuilders in general. And indeed equity valuations for homebuilders have already sharply fallen, by about 40% relative to their peaks of last year. Does the earliest bust of the housing sector relative to the overall economy imply that homebuilders’ equity valuations - that have already sharply fallen – will bottom out earlier than those for the general stock market during the coming slowdown and recession? Not necessarily as the sharp fall of the housing sector and the depth of the housing bust may be much deeper and more protracted than that of the overall economy. So, one cannot assume that housing sector’s stock market valuations will bottom out before the overall stock market does during the coming economic downturn.
The discussion above clarifies what one should expect if – as I have predicted – the US slowdown accelerates into a hard landing and a recession: based on historical experience the stock market is likely fall sharply by about 28% from peak to the trough of the equity market before it is starts to recover in the late stages of the recession. So beware of the large amount of bullish spin that is being peddled today by bulls that are now starting to recognize that a hard landing or a recession is more likely: they need to spin the bad news about the economy as suggesting that such bad news are actually very good news for the stock markets. For these perma-bulls good economic news are very good for the stock market and bad economic news are also very good for the stock markets (as the reaction (“I guess it is probably a buying opportunity”) to my bearish call by the Squawk Box anchor interviewing me last week suggests. But savvy investors will not let themselves to be fooled by such non-sequitur arguments and will cautiously adjust their portfolio to reduce the risk of being stuck in a bear market when the recession actually gets under way.
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