The Market Response to Recessions

by: Jeff Miller

Each day the market gets "new information" about a slowing rate of economic growth. If the rate of economic growth slows enough, it can and will be interpreted as a recession, when the NBER does a retrospective analysis of the data. What does this mean for investors?

An Interesting Table

Let us take a good look at some data from the Wall Street Journal, and highlighted by The Big Picture.

An objective look at this table suggests a major disparity between events of the 70's -- Watergate, Arab Oil Boycott, double digit inflation and unemployment, double digit interest rates -- and the more recent history of the last forty years. The only significant decline associated with a recession happened from the over-valued market of the Internet bubble. Current market PE ratios are vividly different from that era.

A second question relates to recession dating. For almost a year, starting with the low GDP reports in Q107 and especially now, many pundits have suggested that we are already in a recession.

The "official" recession dating takes place after a major decline has been observed. At that point, the NBER dates the recession, the points used in these charts, as the prior peak in output.

Our Take

The most important question for investors and traders is how much of the slowing economy is already reflected in forecasts, earnings projections, and stock prices. Careful readers of bearish pundits should be asking the question raised by the table:

If the recession really is underway, hasn't the market already reflected reduced earning potential?

We believe that forward earnings have reflected recession expectations for many months, driving forward earnings yields to low levels when compared to other asset classes.

Each day brings new and redundant information, completely consistent with slowing GDP growth. The market responds, each time, as if this is fresh information. Slowing growth implies a mixed picture from companies. We cannot expect them to make wildly bullish comments on prospects.

Those who wait for this optimistic look from companies will have waited too long.