Should You Buy Stocks Before the Economy Recovers?

You hear it all the time: “You need to own stocks before the economic recovery begins;” “The S&P 500 (SPY) will recover 6 months before the recession ends;” “The market is a discounting mechanism.” Some of this is true. The market is clearly a discounting mechanism, but there is no evidence proving that it discounts well ahead of an economic recovery. 50 years ago this might have been true, but this ain’t your granddaddy’s stock market.

In the day of high-speed technology, discount brokers and real-time news the markets move quickly and discount news almost as fast. The markets have undergone a phenomenal technological upgrade in the last 20 years. The introduction of discount brokers has made investing more mainstream. The internet makes news available immediately to an incredible number of people. News is disseminated immediately and stock orders are placed within seconds. The result has been an evolution in the approach to investing.

Technology has created an entirely new kind of investor: a short-term investor. In the 1950s, when Benjamin Graham became the grandfather of “buy and hold investing,” it was difficult to trade stocks. The news was slow (hello, Pony Express!), orders were difficult to place (good-bye, Merrill Lynch - literally!) and investing was a game for the upper class. It didn’t make any sense to buy a stock for three months and sell.

But the buy and hold mantra has lost its grip on the investing public as the market has evolved. Investors don’t have to hold stocks and wait for the dividend payments to show up once a quarter in their mailbox. The free market itself evolved and opened doors to a faster more furious kind of investor and ultimately a market with a shorter timeframe. The result is a stock market that doesn’t discount as far in advance as it once used to - and the evidence is clear in the last 20 years.

The main influence in this evolution to a market with shorter duration has been corporate interaction with the public. As technology has evolved and news has become more readily available, companies have become more focused on interaction with investors. Investors demand answers in real-time and companies are more and more willing to feed the short-term hunger of investors. The result has been a sharp focus on quarterly reports. This focus on quarterly reporting has led to a shorter investment timeframe.

The following chart corroborates the evolving market hypothesis. In the two major recessions during the modern market (’91 and ‘01), the market actually bottomed in unison or after GDP bottomed. In the ‘91 recession, GDP bottomed at -3% in Q4 of 1990. The stock market did not make a rebound until the 4th quarter of the same year. During the ‘01 recession, GDP bottomed at -1.4% in Q3 of 2001, but the market did not bottom for another year. Buying stocks before GDP rebounded was not beneficial. In the case of the 2001 bear market it was a recipe for disaster.

Clearly, two recessions is far from enough data to come to any sort of airtight conclusion, but the lesson is clear: be wary of anyone who tells you you need to buy stocks before the economy recovers; it’s the second mouse that gets the cheese.

Sources:

• Bea.gov
• StandardandPoors.com

Comments

[CautiousInv...:]

"The market is clearly a discounting mechanism, but there is no evidence proving that it discounts well ahead of an economic recovery"

That's patently wrong.

There are countless studies of recessions that have measured market troughs and compared the dates of these troughs against the end of the recession.

In the last nine econmomic contractions, the market has anticipated the end of the recession by 2 to 8 months with 4 months being the median.

In one of the two recessions you discuss, the market bottomed in October, 1990 while the recession ended in March, 1991.

The real problem is appreciating that the market makes, on average, three bottoms during the bottoming process.

Jan 20 08:22 AM

[investor88:]

Most useful article debunking the thought that you must buy before the recovery. Better to buy as the market recovers, never mind missing some so long as you make a profit.

Jan 20 08:23 AM

[Jim Hawthorne:]

Thanks for a timely and thoughtful article! It is true that bottoming is a process rather than a singular event, as I learned the hard way back in the fall of '02.
I foolishly took the advice of the 'experts' and began building positions in Sept., 2002, and didn't recover until well into the spring of '03.
2003 was a great year, but had I been more disciplined and waited until the markets began to heal with higher lows and higher highs, I would have been a good 12 to 15% higher at year end than was the case.

Your point that trading in the markets has indeed evolved into an environment that demands nimble flexibility is well taken.

These are times for disciplined trading, good risk management, and capital preservation. Good luck!

Jan 20 08:31 AM

[Tradememe:]

Actually, because of high-speed technology the lag time between market recovery and economic recovery is going to be much shorter. Good luck trying to pick the right point to get back into the market.

Jan 20 08:34 AM

[athena:]

Follow the money, buy emission traders, alternative energy ETF's etc.
Buy what Gore and Pelosi already did. And let Gary Gensler do what he was hired to do...make them a fortune.

Jan 20 09:15 AM

[Sephirothngoi:]

If you wait for the Robin, Spring will be over.

Jan 20 10:02 AM

[The Hern:]

I think the time is right to dabble in the market now that our new President will be making policy changes that will positively affect the market. Just be sure to put your stop loss orders in to minimize any losses at 10-15% and you just might make some money. This bear has gone on long enough so a turnaround should be coming and you don't want to be late for the party.

Jan 20 10:03 AM

[kelm:]

If one looks back over this crisis you'll see that there have been multiple times where Saudi Princes, Sovereign Wealth Funds, private Equity funds, the perma-bear and even the Sage of Omaha have all entered the market in force believing that it is good to take advantage of the dips and buy before the market starts to recover. Each one of them is underwater - some significantly. If you out-waited all of them and bought near the end of October - you'd still be under water. This crisis has consistently shown itself to be deeper and have a longer time-constant than what we have seen in the past. So prudence demands waiting till you see some real evidence. One suggestion is wait till the next time you see some of the great investors enter the market...then wait a bit longer.

Jan 20 10:05 AM

[bobbobwhite:]

What is missing from all the above comments and in the article is that, due to artificial and band aid repairs over many years, this depression may be the mother of all depressions and one that will drag America down for a long time before recovery. And, if that is true, then any stock market rebound happening 4 months or so before any real economy recovery is still many years off thus nearly meaningless at this point.

Forget about the market, as the main problem for Main Street is what to do to survive as best it can until better times come.

Jan 20 10:34 AM

[Prudent Man...:]

Tell me when the economy is recovering and I will buy stocks in those companies that will benefit.

No exactly rocket science with all these charts and historical nonsense.

The missing variable is the "when".

Jan 20 10:39 AM

[The Pragmat...:]

There are just as many studies proving your theory wrong as well. Specifically, Russell Napier's book "Anatomy of a Bear" and Claessens, Kose and Terrones study "What happens during Recessions, Crunches and Busts". You should check them out. Very useful info.

Also, GDP troughed at -3% in Q4 of 1990 according to the BEA.


On Jan 20 08:22 AM CautiousInvestor wrote:

> "The market is clearly a discounting mechanism, but there is no evidence
> proving that it discounts well ahead of an economic recovery"

>
>
> That's patently wrong.
>
> There are countless studies of recessions that have measured market
> troughs and compared the dates of these troughs against the end of
> the recession.
>
> In the last nine econmomic contractions, the market has anticipated
> the end of the recession by 2 to 8 months with 4 months being the
> median.
>
> In one of the two recessions you discuss, the market bottomed in
> October, 1990 while the recession ended in March, 1991.
>
> The real problem is appreciating that the market makes, on average,
> three bottoms during the bottoming process.

Jan 20 10:47 AM

[alphadominance:]

Timing the market has been shown repeatedly to be little better than taking your nest egg to the casino. Making fixed dollar investments over time is still a very effective strategy to mitigate risk and take advantage of opportunities without betting the farm. While I agree that holding securities indefinitely may no longer be effective, there is nothing wrong with averaging in and taking money off the table on a case by case basis when you have a decent gain. The average investor lacks the time or savvy to play the speculative gain anywhere near effectively.

Jan 20 11:08 AM

[elliot_mllr:]

Don't they ring a bell at the bottom?
I disagree that buy-and-hold investing is dead. Market timing is impossible. As of today Buffet may be under water with his recent purchases but the game's not yet over, or even in the second inning.

Jan 20 01:21 PM

[CautiousInv...:]

"There are just as many studies proving your theory wrong as well. Specifically, Russell Napier's book "Anatomy of a Bear" and Claessens, Kose and Terrones study "What happens during Recessions, Crunches and Busts". You should check them out. Very useful info.

Also, GDP troughed at -3% in Q4 of 1990 according to the BEA."

Maybe I was not precise in my language. Market troughs during recessions precede the conclusion of the recession as defined by NBER. And while the economy may have had its worst quarter in 1990 Q4 the recession did not end until March,1991. As I stated the market bottom was reached in October, 1990.

Jan 20 01:45 PM

[notsosmart:]

its a new world that now includes phony rated AAA worthless paper,lying ceo's,selfserving boards,not too trustworthy accounting & accounting firms,lack of transparency,lack of accountability, & musical chairs & bailouts for the scammers,scoundrels,&a... crooks.how does that blend into the charts & graphs? the anal sts dont know anything.its all ponzi.made-off is a piker compared to wall st & the gov.

Jan 20 02:09 PM

[The Pragmat...:]

Thanks for clarifying. The purpose of the article is not necessarily to discredit the idea that the market bottoms before the economy, but rather to approach the "buy stocks before the economy bottoms" mantra with a heavy dose of skepticism. Clearly, it has not always been true that the market bottoms before the economy....


On Jan 20 01:45 PM CautiousInvestor wrote:

> "There are just as many studies proving your theory wrong as well.
> Specifically, Russell Napier's book "Anatomy of a Bear" and Claessens,
> Kose and Terrones study "What happens during Recessions, Crunches
> and Busts". You should check them out. Very useful info.
>
> Also, GDP troughed at -3% in Q4 of 1990 according to the BEA."

>
>
> Maybe I was not precise in my language. Market troughs during recessions
> precede the conclusion of the recession as defined by NBER. And while
> the economy may have had its worst quarter in 1990 Q4 the recession
> did not end until March,1991. As I stated the market bottom was reached
> in October, 1990.

Jan 20 02:12 PM

[Demographer:]

Two points to be made here

Firstly a very detailed recent paper by Claessens, Kose and Terrones titled "What happens during Recessions, Crunches and Busts" comes to the broad conclusion that there is not much evidence to show equities recover months before the economy does. In fact the evidence from previous US downturns shows that private consumption, and output all turn up at about the same time as equities.

Secondly all recessions are not the same and any general observations will have exceptions. Other research shows that the most severe and longest recessions are those proceeded by a financial crisis. Sound familiar? These Balance Sheet Recessions are far more damaging to confidence than Inventory Recessions based on boom and bust of the trade cycle and there is most unlikely to be a strong rally months ahead of economic recovery when the issue is that there is real fear that asset values could still decline.

I intend to live by a simple rule. If most of us didn’t see this one coming then most of us probably won’t see it finishing. There are multiple bottoms in a severe downturn and in the long slow recovery there will be plenty of opportunities to make money without getting manic about picking the exact bottom.

Jan 20 05:15 PM