By looking back at previous stock market corrections, I hope to provide some clarification about corrections and recessions - when they occur together and when they don't. My analysis will be at the macro level, but the macro is a sum of the micro, and fundamentals are relevant at both levels.
By any other name a correction
Stock market corrections, crashes, and bear markets have specific definitions. However, for simplicity, I'm going to call every correction/crash/bear market event a "correction."
Stock market corrections occurring with recessions
Table 1 shows stock market corrections that have occurred with recessions since the 1973-1975 downturn. These corrections had an average duration of 13 months and saw an average decline of 33.5%. The stock index values used here, and in Table 2, are from the S&P 500.
Major stock market corrections without recessions
Without fail, the steady gains of the stock market during a business cycle are often marred by corrections, some small, some large, but none associated with a recession. I'm highlighting some of the most notable in Table 2. Correction #2 was associated with Black Monday, October 19, 1987. On that day, the correction was widely acknowledged to have been caused by forced selling due to margins, risk, and program trading. Although most of the correction happened on Black Monday, the market had peaked in August, and after Black Monday it rolled sideways until December. Although the largest decline happened on one gut-wrenching day, the entire correction stretched over four months.
Comparing corrections with and without recessions
The differences in duration in months and percent decline in Tables 1 and 2 are striking. On average, corrections with recessions are nearly three times as long as non-recession corrections, and the average percent decline is almost twice as much. Also, as shown in Table 2, the current correction (6) is well below average.
At this point, some obvious conclusions can be made. First, if the economy falls into a recession, the stock market corrections are more severe and longer than if there is no recession. Relatedly, second, if the economy is not in recession territory, the stock market may falter, but without a recession, it will recover within a few months.
However, these easy conclusions are made after the fact. What about our current correction? Are there economic factors that point to a looming crash? By looking at past corrections and some long-term trends, I hope to address these questions.
Does the stock market cause recessions?
While a stock market correction can be a contributing factor to recessions, evidence suggests that the economy is generally well on its way to a recession before the stock market takes any real notice. An example of this is the January-July 1980 recession (B, Table 1). The recession started in January, but the stock market began its decline a month later. Difficult to argue the stock market as a recession factor when it is moving upward as the recession starts. The recession that started the next year, July 1981, was preceded by a stock market that peaked one month prior to the start of the recession. It is a stretch to think that a one-month tumble in the stock market caused a recession. In addition, we see something similar in the July 1990-March 1991 recession (D, Table 1). The stock market began its descent on the same month the recession started. Lastly, we can go the other way. After the 2001 recession ended in November 2001, the stock market continued downward for another 11 months. If the stock market has such pull on the economy, how can the economy be effectively recovering while the stock market is collapsing? These examples point out that more is at play than a stock market correction when recessions happen (I talk about the corrections prior to the 2001 and 2007-2009 recessions later).
Why are some corrections associated with recessions and others are not?
To provide some perspective on corrections/recessions versus corrections only, I will start with the correction that coincided with the July 1990-March 1991 recession. As I showed in Table 1, both the correction and recession started in July.
Using the BaR Analysis Grid©, in Grid 1, I'm showing the economy in January 1990, six months prior to the start of the July correction/recession. (If you are not familiar with the BaR, you can read about it here. Also, the data sources for the BaR are shown at the end of this article).
The MoC (mean of coordinates), which is the average of all plotted points and shows the overall condition of the economy, is in the expansion grid and above the baseline (recession threshold). Its position indicates the economy is stable and growing. For reasons that are too lengthy to explain here, for previous business cycles, the algorithms used for the BaR will show some of the economic indicators, and consequently the MoC, lower than if this were the current business cycle. However, the MoC is still relevant for the time and comparing grids within this business cycle is meaningful.
Grid 2 displays the economy three months prior to the correction/recession. The MoC is noticeably dropping towards the baseline, the recession threshold. All the while the stock market is still moving upward.
In Grid 3, we see the economy one month prior to the correction/recession. Without doubt, the bottom has fallen out of the economy. However, the stock market is near its peak. In June and July of 1990, the S&P 500 hovered between 350 and 370. There are no fundamentals here to support an increasing stock market. Investor psychology and/or biases are carrying the market. During August, one month after the recession started, the S&P dropped to 307.
I have already demonstrated in an earlier article that the MoC correlates closely with changes in GDP (read here; see Chart 1). To confirm this, below is a chart from FRED that shows percent change in GDP for the same time frame shown here, 1Q and 2Q of 1990. The leftward shift in the MoC seen in Grids 1-3 corresponds with the declining GDP. This is one reason the BaR Analysis Grid is so helpful. It gives you a pretty good idea where GDP is going long before its quarterly update.
Source: Bureau of Economic Analysis
There is a challenge going back to 1987 as less economic data was tracked back then. However, the BaR functions as it should, with the MoC indicating overall economic conditions.
As a contrast to the correction/recession above, looking at the Black Monday correction (#2, Table 2), the BaR shows some meaningful differences. Despite a 33% drop in the stock market, the economy never approached the recession point.
However, there are some key economic indicators that were not favorable during this time. Note that on Grids 4 through 7, consumer sentiment and nonfinancial profits are near or below the baseline. This indicates that there were some reasons for investors to be a bit jumpy at the time.
Grid 4 shows the BaR three months before Black Monday and one month before the stock market correction began. As seen, the MoC is in the expansion quadrant, and it really isn't that far from where it was shown in Grid 1 (note that Grid 4 has a max of 60% on the axes, while Grid 1 has 50%). But the MoC moves very differently as we progress through the 1987 correction.
Grid 5 shows the economy in August, which is when the stock market peaked. The MoC remains stable.
Grid 6 shows the economy in October, when the stock market crashed. Several indicators are showing negative rates of change, but the MoC has not been pulled down appreciably. The consistency of the MoC from Grid 4 to Grid 6 is important. One could argue that the economy does look somewhat iffy, but what is important is that the MoC didn't drop as it did just prior to the 1990-1991 recession. Further support comes from GDP changes. They too were favorable during this period, as I will show momentarily.
The next grid, Grid 7, shows the economy in January 1988, three months after Black Monday. At this point, the stock market has begun to move upward. In fact, from the December 1988 lowest closing to January 1988 highest closing, the S&P 500 increased 17%. The economy shows some softening, but nothing close to a recession. Importantly, nine months later, the MoC is 13% above the baseline.
Again, just to confirm that the MoC reflects changes in GDP, the below chart highlights the percent change in GDP during 2Q and 3Q of 1987, which corresponds with Grids 4-6. The right or left shifts in MoC correspond with variation in the GDP percent changes, with GDP lagging slightly (I'm not suggesting there is a perfect correlation here, but the empirical evidence shows a steady correlation).
Source: Bureau of Economic Analysis
In Chart 1, I'm showing most of the recessions and corrections listed in Tables 1 and 2. I will use some of these events to see if the same patterns show up that were seen in the 1990 correction/recession and 1987 correction shown above.
Table 3 shows the corrections/recessions for 2001 and 2007-2009. I'm only analyzing events after the 1990-1991 recession because there are more economic indicators to look at for these periods, giving more credibility to the results. In this table, I'm looking at the changes to the MoC relative to the rate of change (movements to the left or right on the BaR) to see if the pattern is similar to what was seen in Grids 4, 5, and 6. There is consistency. From six months prior to, and until the correction, the MoC shows a steady negative rate of change as the economy progresses towards the correction and subsequent recession.
Table 4 shows the same recessions, but it measures the distance of the MoC from the baseline (horizontal line on the BaR). Similar to Grids 4, 5, and 6, the MoC is dropping towards the baseline, indicating that the economy is weakening.
For the three correction/recessions examined (Grids 1, 2, and 3 and Tables 4 and 5), the patterns are similar, showing a deterioration of the economy.
Importantly, the recessions shown in Tables 3 and 4 (E and F on Table 1), the market corrected before the recession, and considerably so prior to the 2001 recession after the dot-com bubble crashed. Chart 2 clearly shows how during the dot-com bubble the economy and market were diverging well before the market correction in 2000, showing how fundamentals were being ignored. A similar pattern of irrational exuberance happened prior to the 2007-2009 recession.
If something other than fundamentals is driving the market to such heights, no one can be blamed for wanting to stay in. But it is a dangerous game when the fundamentals don't support the market because there will eventually be a correction (and what a correction is was - a 47% drop over a 30-month period [E, Table 1]).
Other corrections with no recessions
Table 5 shows four corrections that were among the most severe, but were not associated with recessions.
Like Table 3, Table 5 shows the rate of change of the MoC. With the exception of #6, from six months to the correction, the MoC shows a decline. However, there is a notable difference from Table 3. The rates of change for the MoC are all positive, with the exception of #3, where the percent was negative at the time of the correction (however, three months later, the rate of change was 6.4%). The positive rates of change in Table 5 indicate the economy is holding steady, a marked difference from Table 3.
Like Table 4, Table 6 shows the distance the MoC is from the baseline. The stability of the percentages shows the resilience of the economy during these corrections and why there was no recession.
Importantly, looking at our current correction (#6), the economy is relatively strong. However, the last update of the BaR, May 4, 2018, showed that the MoC has swung significantly to the left, as shown in Grid 8. At the end of December 2017, the MoC was a positive 19.2%, so it has made a large leftward swing. Even so, the economy is nowhere near a recession.
I think it is fair to say that the MoC helps to distinguish between corrections with recessions and corrections without. Currently, the BaR grid indicates that the current correction is unlikely to turn into a more serious correction/recession (you can see BaR grids from June 2009 to present here). The recent leftward shift in the MoC invites some caution. We may not be out of a correction period just yet.
One last point is that an inverted yield curve, which has been a reliable recession indicator since the late 1960s, should also be considered as an indicator of a looming, serious stock market corrections. In my last article, using the BaR, I showed what the economy looked like when the yield curve inverted (read here). In that article, the BaR showed that the economy is already in real trouble when the yield curve inverts. The reason I didn't discuss the yield curve spread here is that I wanted to connect the economy and stock market behavior. However, an inverted yield curve should be considered not only an indicator of recessions but also of severe market corrections.
Data sources for BaR Analysis Grid
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.