Market forces: how does a recession affect the sharemarket?
While the Australian economy is holding up relatively well in the midst of a global downturn, investors are still bearing the brunt of the worldwide market turmoil.
With predictions of a global recession stretching well into 2010, and an assumption that Australia will not be immune, does this mean investors can expect more pain? The answer, it seems, is maybe not.
The world is in one of the most serious economic and financial crises since the 1930s depression. Economies have rapidly contracted, the world’s financial system is in disarray and unemployment queues are lengthening.
In response, governments across the globe are undertaking massive programmes to avoid a repeat of anything like the Great Depression. We’ve seen trillion dollar stimulus packages, government guarantees of banking deposits and lowered interest rates amongst a whole host of other measures in an attempt to stimulate the economy.
In relative terms, Australia has fared well so far. We’ve experienced negative economic growth and a rise in unemployment, but recent developments have been more positive. These include significant gains in share prices, strong retail sales and an unexpected positive increase in the March quarter GDP.
A common assumption is that a grim economic situation naturally extends to the sharemarket. However this is not necessarily the case. The recent recovery we’ve seen from equity markets is a good example of how sharemarket returns can be positive, even in a seemingly gloomy and bearish environment.
If you examine previous recessions an interesting pattern emerges. What we see is that the sharemarket is a discounting mechanism that factors in economic distress before it becomes evident in the wider economic picture. Hence, while a dip in the sharemarket can suggest troubled times ahead, history indicates that a rising sharemarket during a recession often occurs before a bounce in the economy.
Looking in the rear view mirror
It’s interesting to look at how sharemarkets have reacted in US recessions since the 1950s.
| US equity market returns | ||||||
| Date | During | 1 Year | 3 Years | 5 Years | 7 Years | |
| March 2001 – November 2001 | -1.8% | -1.1% | -1.0% | 2.2% | 1.9% | |
| July 1990 – March 1991 | 5.4% | 8.9% | 8.0% | 9.6% | 15.1% | |
| July 1981 – November 1982 | 5.8% | -18.2% | 4.8% | 12.5% | 11.0% | |
| January 1980 – July 1980 | 6.6% | 13.5% | 8.4% | 9.5% | 13.3% | |
| November 1973 – March 1975 | -13.1% | -27.1% | 2.1% | -0.3% | 5.6% | |
| November 1973 – March 1975 | -13.1% | -27.1% | 2.1% | -0.3% | 5.6% | |
| December 1969 – November 1970 | -5.3% | 0.1% | 8.6% | -5.7% | 2.2% | |
| April 1960 – February 1961 | 16.7% | 20.1% | 8.7% | 10.4% | 8.1% | |
| August 1957 – April 1958 | -3.9% | 5.6% | 8.0% | 5.5% | 8.8% | |
| July 1953 – May 1954 | 17.9% | 24.8% | 25.9% | 13.8% | 12.2% | |
Source: Thomson Financial Datastream.
As you can see, returns from equity markets were positive in five out of the nine recessions. Furthermore, if we look at the returns achieved over the three years after the start of the recession, on all but one occasion sharemarket returns were positive.
In the 1990’s the rebound in equity markets occurred before the end of the recession. This is the typical pattern. In fact, in this case the rebound started closer to the start of the recession than the end and the return from US equities over this period was positive.
The recession of the early 1980s lasted longer, but similar conclusions can be drawn. In particular, the recovery in the sharemarket commenced before the recession was officially over.
It pays to be cautious in drawing conclusions from historical returns. We can’t assume a perfect correlation between the period of economic contraction and the period of negative sharemarket returns but history tells us that equity markets tend to lead the real economy.
Recessions and share prices
As I’ve explained, share prices are forward looking and already incorporate what the market expects. This was evident in Australia when the sharemarket fell around 50% from the highs recorded in November 2007 before we even entered a recession. Clearly, a significant part of this decline reflects the pricing in of the (likely) future recession.
Another factor is that investor sentiment is a key driver of market prices. Sentiment can swing very quickly from strongly optimistic to complete panic. This can mean that equity market returns turn sharply negative immediately before and during the early stages of a recession.
The opposite can also occur. As sentiment and confidence improves, equity markets can bounce back very strongly and long before the economic data improves.
Implications for investors
It’s important not to translate what’s happening in the economy directly to sharemarket returns. While clearly economic news will have an impact, what’s more important for returns is what’s already priced in and whether the new information is better or worse than this.
In addition, in this type of environment, commentators and investors often claim to sit on the sidelines and wait for one of two signals before beginning to invest again: strong returns from equity markets and/or better news on the economy.
Unfortunately, waiting for these signals often means you have missed much of the rebound and hence significant returns.
Trying to time the markets like this is a dangerous strategy and can prove very costly. There really is no bell that will signify to investors that it’s OK to jump back into markets.
The historic relationship between recessions and sharemarkets is compelling but not a hard and fast rule. No two recessions will be exactly the same. In the absence of perfect foresight, what can you do? Resist the urge to cringe when an investment ‘expert’ wheels out the mother of all motherhood statements - “focus on the long term”. Like most clichés it exists for a reason; namely that the long term is more predictable than the short term.
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