Yes, an economic downturn is upon us, but that doesn’t mean the stock market will follow
The economy is heading into a recession. Most economic predictions are dire, forecasting spikes in unemployment and significant contractions in GDP as social distancing and quarantine bring business in some sectors to a screeching halt.
For most people, the natural reaction to a looming recession is the desire to sell out of equities to avoid future losses. But this is not the best strategy for an important reason that not everyone understands: the stock market and the economy are not the same thing.
Yes, the stock market and the economy are intimately related, but they do not rise and fall in tandem. Just because the economy is contracting does not mean that stock market returns will drop too.
In fact, history shows us that GDP is not a good predictor of future stock prices. It’s actually the other way around: the stock market is a predictor of future GDP – which is precisely what we’re seeing right now.
The stock market is not the economy
The chart below shows no discernible relationship between economic growth and stock market returns for each year from 1990 to 2019. Over the 30-year period this chart depicts, the correlation coefficient between GDP and stock returns was only 0.15. (See footnote for definition of correlation coefficient.)
This is typical. Over time correlations between GDP growth and stock market returns vary from weakly positive to weakly negative. From 1930 to today, the correlation between GDP and stocks is 0.14, and since World War II, it’s a mere 0.04.
The primary reason the correlations are so weak is that the stock market anticipates economic growth (or decline) and responds before the economy. This phenomenon becomes more apparent when we compare GDP growth to the prior year’s stock market returns, which shows a dramatic rise in correlations.
Research published by Credit Suisse explains this effect:
Investors’ decision-making tends to anticipate the economy’s changed circumstances, and the empirical evidence supports this claim. Stock market fluctuations predict changes in GDP, but movements in GDP do not predict stock market returns. Over time, forward-looking predictions of economic change are impounded in today’s fluctuations in the stock market.
Looking at stock market returns during years when GDP was negative also supports this conclusion. Since 1930, we’ve experienced 18 years of negative GDP growth, five of which were in the 1930s. In 12 of those 18 years, stock market returns were positive, in most cases well over 18%.
The Great Recession as a case study
The stock market typically recovers before the economy because, at some point, the market has already priced in the bad news, and investors start to anticipate a recovery. The bottom of the market during the Great Recession is a good example.
The S&P 500 bottomed on March 9, 2009, after dropping 57% from its peak on October 9, 2007. On March 9, the economic news was bad and getting worse. On March 6, the U.S. Bureau of Labor Statistics had announced that unemployment for February was 8.1%, a whopping half point increase from the prior month. Unemployment would climb to 10% by October. The economy was still contracting in March 2009 and didn’t reach the trough of the recession until four months later in June. Yet, the market low was on March 9 and from there, the S&P 500 climbed over 500%, including dividends, during the next nearly 11 years.
During the stock market’s climb, the bad economic news kept coming: concern about inflation because of the massive expansion of the Fed’s balance sheet, the European sovereign debt crisis, worries that the Euro would collapse, and the downgrading of U.S. Treasuries. As the market recovered after the March 2009 bottom, many investors thought that it was a “dead cat bounce” and the market would head to new lows. But it didn’t. March 9 remained the bottom.
Do you know more than the market?
In the current crisis, we don’t know whether the stock market has already bottomed or whether is will head lower. What we do know is that the market will bottom at some point, and the next bull market will start while the financial news is still dire.
By the time you hear new scary information about the COVID-19 and its economic effects, you can almost be certain the market has already absorbed it. It’s surprises that move markets, not expected news, because expected news has already been priced in.
Stock prices over the last month illustrate this point. The severity of the COVID-19 pandemic was a surprise, and the stock market reacted to the economic reality of the COVID-19 pandemic by dropping 30% in 22 days – the fastest decline ever. During the financial crisis, it took 250 days for the S&P 500 to drop 30% and 31 days during the crash of 1929.
As an investor, it may give you comfort to know that the market reacted quickly to the COVID-19 crisis and has already priced in a lot of bad news, including forecasts of a looming recession. Of course, having all this bad news priced in does not mean that the market has bottomed – market bottoms are only known in retrospect.
So, if you’re still tempted to change your investments because of those forecasts, ask yourself these questions: Do you know something the market doesn’t? Are you weighting something the market has already absorbed differently than everyone else? If so, do you have a good reason? If the answers to these questions are “no,” then it’s probably best to resist the urge to sell out of the market or to buy additional stock (unless you are rebalancing based on your investment discipline).
What to do
During times of market volatility, and even the threat of a recession, your first step should be to continue to rely on the investment discipline you put in place when times weren’t so scary. For most people, this means sticking with the asset allocation you established before the COVID-19 crisis and rebalancing according to that allocation.
Second, ensure that you have enough cash and safe assets to make it through the market down cycle. This means having at least one year of portfolio withdrawals in cash and a healthy allocation to high-quality bonds.
Third, you should resist the temptation to make investment decisions based on what you read in the news about the pandemic or the economy going forward. By the time we learn this information, it’s already been factored into stock prices.
Finally, in strong bull markets, it can be hard to find great investment opportunities because most stock is expensive. In bear markets, great opportunities abound as investors sell assets for reasons other than the fundamentals of the investments. If you can stomach it, be on the lookout for fat pitches and consider swinging at some of them.