Market Response to Recessions

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 Q1 '07 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?

Regular readers of "A Dash" know that 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.

Comments

[Dividends4Life]

Interesting read. I too believe the street has factored in a mild recession. If it doesnt happen, there will be some upside.

Best Wishes,
D4L

[Mike C]

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

Excellent point! And I completely agree. Stock price action discounts the future. It does NOT react to the present headlines. But IMO that cuts both ways, in terms of either improving fundamentals and declining fundamentals. If one waits for the "all clear" sign to go long, you'll miss alot of the upside. At the same time, it is potentially dangerous to ignore/discount what initial deterioration in stock price action might be saying.

"Each day brings new and redundant information, completely consistent with slowing GDP growth. The market responds, each time, as if this is fresh information."

So is the market "wrong"? Maybe, and then again maybe not. Here is what Richard Russell had to say the other day:

"The "experts" are now coming out of the woodwork. Predictions are filling the air like mosquitos on a hot summer night. "There'll be no recession." "There definitely will be a recession." "We're already in a recession." The fact is that it's all guesses and opinions. The market is a law of its own. As the Dow and the Transports break to lower levels, assuming that they do, the situation will become more dangerous. Personally, I've learned to put little stock in the predictions of experts or even the Wall Street professionals. ****I go with the market. I bow to the wisdom of the stock averages.****"

I added the asterisks. Interesting point we are at right now. What has the market already discounted? We'll find out in th coming months. In the meantime, for all the hand-wringing and teeth knashing going on with CNBC guests, the fact of the matter is the current decline is peanuts. We're down 10 to 12% on the major indices.

To steal from Random Roger, we are "down a little". Is this the mother of all buying opportunities in terms of the broad market, or this is just a temporary rest stop on the road to "down alot". Depending on how one answers that question, is the difference between aggressively deploying any cash reserves versus holding some cash or hedging long bets a bit.