In Part 1, we learned the basics of a recession, how they’re confirmed, and indicators to be aware of. Now that we’ve got a basic knowledge, we need to take things a step further and understand how this relates to our money. In order to do so, we have to analyze how the stock market and recessions relate with one another.
First, we can recognize that stock prices typically decline during periods of negative economic strength. When we as consumers have less money to spend, the demand for goods and services weakens. When demand weakens, businesses offering these goods and services see declines in revenue and need to find ways to reduce their business expenses. They do so by cutting jobs and delaying or eliminating pay raises, which leads to higher unemployment. With higher unemployment, there are less people making money, and since they can’t spend money they don’t have, the demand for goods and services fall even further and the economy spirals into a recessionary environment. As we learned in Part 1, this is all part of the business cycle.
There are various factors that play into what makes the stock market go up or down at any given time, but ultimately, supply and demand matter most. If a company’s supply is greater than the demand for that supply – or if demand simply drops due to other factors – that company’s revenue, profits, and other metrics of financial importance are likely to take a hit.
More importantly, when investors observe a decline in a company’s financial outlook, naturally, they are less willing to buy their stock (or if they own it, they might sell it) and thus, the stock price will fall. There are times when some people know something about a company’s outlook before it’s even made public, and they sell it for those reasons, but this not-so-well-known fact is a topic for a completely different article.
Today, we want to specifically discuss what comes first, the chicken or the egg? I mean… does the stock market crash first, before a recession occurs, or is it the other way around?
At the end of the day, the stock market reflects investors’ confidence in the future financial health of all companies within it. Corporate earnings are directly related to the health of the U.S. economy, which makes the stock market a leading economic indicator for the economy. So, when you think about it, a stock market crash portrays a significant loss of confidence in the economy and when that confidence isn’t restored fast enough, we experience a recession.
To confirm the above, we can further analyze the performance of the S&P 500 before and during the 12 recessions we’ve seen since World War II. The chart below shows that stocks, on average, were actually up 5.6% during recessions. It was the time period leading up to the recession (from market peak to start of recession) that stocks were negative on average -8.0%.
If you look further into all 12 recessions, you would find that stocks did better during the recession 11/12 periods and in six of those periods, stocks were actually up to the tune of an impressive, double-digit return!
This shows that stocks tend to be forward-looking when it comes to a recession. In other words, waiting for economic confirmation that a recession is present before taking action will likely force you to miss out in the recovery. For this reason, it’s important to implement a proactive strategy or align yourself with someone you trust who can implement the strategy on your behalf.
Categories: Educational Articles, Market Commentary, Zak Leedom