Investing on the Cusp of Recession

by: Eric Boughton, CFA

Many market participants seem to be looking past any potential recession towards the recovery in the stock market that is sure to precede the official end of the recession. Stocks are a discounting mechanism, they say. Net levels of bullishness, both among individual investors and institutions (see the most recent Advisor Intelligence survey and the Barron's Big Money poll for examples), is therefore on the rise.

It seems to me that no one really knows whether we will have a recession, or how deep it will be. I happen to believe we will have a serious recession.

However, it seems reasonable to test the hypothesis that investing in stocks at the current moment in the economic cycle is a good idea, especially in light of the upcoming first quarter GDP report. Let's start with the raw statistics.

Since 1947, there have been 35 quarters in which GDP has been reported as negative. Investing "in the face" of these recessionary periods has turned out not to be a terrible idea, on average. Specifically, buying the S&P 500 on the day when the negative GDP is reported (assumed for my purposes to be the last day of the month following that quarter end), and holding for a full year, resulted in an average annualized return of 9.36%, as compared to the average annualized return of the S&P 500 over that same time period of 11.64%. 24 of the 35 one-year periods gave a positive return. (This analysis ignores for the moment the issue of restated GDP, since I don't have access to that information before 1996.)

Analyses like this, and anecdotes about stocks' fabulous returns during parts of the 1990 and 1982 recessions, bolster the confidence of investors. I think they miss the mark, however, primarily because they mostly capture periods during which the economy is in the process of exiting, not entering, a recession.

To illustrate that point, consider that only 10 of these negative GDP quarters were preceded by at least a year of positive GDP quarters. Investing in the year following the report of these 10 quarters resulted in an average annualized return of only +0.60%. Average annual inflation over those same 10 one-year periods? 4.49%.

Furthermore, it is probable that quality bond investments performed better than their long-run averages during these periods, given the pressure for lower interest rates caused by the economic weakness.

Given the above, I find it extremely unlikely that stocks, sitting merely 10% off their highs, are discounting anything but the mildest and briefest of recessions.