A slanging match has broken out about whether the US economy is in recession. Everyone agrees that a recession is a contraction in real economic activity, but there’s no consensus on how deep, widespread and long-lasting the contraction has to be to deserve the “recession” label.
While economists can debate theory, and politicians can explain why it’s the other party’s fault, investors should take a pragmatic view.
Recessions are the part of the business cycle that clears away economic deadwood and sets the stage for the next expansion. Debt is reduced because weaker consumer and business borrowers default and stronger borrowers cut spending. Failed projects and ideas are written off and no longer suck capital down black holes. Bubbles deflate. Frauds are exposed and punished. Workers move, retrain and otherwise position themselves for future economic growth. Businesses refocus on the most promising areas. Obsolete businesses fade away, clearing the ground for innovations.
Painful as they are for individuals and companies, long-term equity investors should welcome recessions. The stock market peaks an average of seven months before a recession begins. The last equity peak on an inflation-adjusted basis was November 2021 and prices are down more than 20% since. If a recession is declared today, it likely started around January 2022. Is it better for investors if the first six months of 2022 were a recession, or if the economy was still in its expansion phase.
Looking at the last 30 US recessions as defined by the National Bureau of Economic Research, equity declines of more than 20% that were followed by recessions within four months meant an average recession length of 10 months during which the real total return of stocks was negative 21%. These were followed by bull market runs averaging a total real return of 135%. That means an investor who bought at the peak before the recession was up 85% after inflation by the subsequent market peak.
Equity declines of more than 20% that were not followed by recessions within four months were much worse for investors. First there was an average of 13 months without stocks returning to the previous peak. That was followed by a 20-month recession on average. Stock losses were only a little deeper than for the first group of declines — down 26% on average versus down 21% — but the subsequent recovery was much smaller — plus 72% versus plus 135%. As a result, the peak-to-peak real total return for 20% equity declines followed quickly by recessions was plus 85%, whereas it was only plus 27% if the 20% decline was not quickly followed by recession.
One obvious explanation for the pattern, although not one I can prove with detailed analysis or data, is that efforts to delay and soften the pain of recessions make them last longer and do less clearing out. If we are not in recession today, it could be because the Federal Reserve kept interest rates so low for so long, and the government engaged in so much stimulus. While those can make life easier for individuals and businesses, and push out the date that recession hits, they might cause more pain and less gain in the longer term.
The other simple story is negative gross domestic product growth in 2022 is caused by supply chain issues, reopening pains and high energy and commodity prices due to war in Ukraine. Although we had two consecutive quarters of negative GDP growth — one popular definition of recession — they could be due to exogenous issues that affect only certain economic sectors, rather than an endogenous cascade of excess debt and misallocated resources over the entire economy. In that case the 20% stock market decline might be a reaction to a supply-side shock rather than a harbinger of recession. The stock market might set a new peak before the next recession.
Unfortunately, I can’t find any historical parallels for that latter story. It might be true, but it doesn’t seem to have happened to the US economy any time in the last 150 years. The two stories we know happen frequently are stock market declines followed by quick, brief, shallow recessions and robust subsequent expansions, and stock market declines followed by delayed, long and deep recessions, with anemic subsequent expansions. If those are the two choices, investors should hope we are in recession.
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