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Recessions and the Duration of Bad News

How do the economy and the market behave in an "average" recession?

William Hester, CFA
March 2008
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The data continue to suggest that the economy is likely in a recession. Jobless claims, payroll numbers, consumer confidence, and various housing measures have all worsened over the last few weeks. If we do assume the economy is already in a recession, a few questions logically follow. When might the economy trough? When can we expect the economic data to improve? When might the stock market “fully discount” the recession and begin to anticipate the next expansion?

Every recession is unique, and the current set of characteristics can't be matched exactly against previous contractions. But averaging past recessions (including particularly nasty recessions, like 1974 and 1982 as well as more mild recessions, like 1991 and 2001) can provide insight about the performance of the economy and the stock market around a “typical” recession.

The charts below show the average change in a set of economic indicators that have been helpful in identifying the turning points around the peaks and troughs of the business cycle. The blue line in each chart represents the average change in the data series over a five-year period, beginning 36 months prior to the beginning of each recession. The light blue lines represent one standard deviation above and below the change in the data series. The red line shows the change in the data for the current cycle, assuming the economy entered into recession in January. The average and current cycle lines are cumulative changes from a base of 100. The vertical black line marks the start of a recession. The last 9 recessions are included, where data for the economic series is available.

Employment

Jobless claims have turned last year's periodic visits to levels above 350,000 into a longer residency this year. The last 6 reports have come in above 350,000, an important threshold that usually leads trends in the employment figures. Jobless claims drift up as a recession approaches and then spike once the economy begins to contract. If they remain on course with their average behavior in past recessions, claims could leap another 25 percent to almost 450,000 within the next few months. Claims data begin to decline an average of 15 months from the start of recession.

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The unemployment rate has edged up only slightly the last few months, encouraging those expecting the economy to skirt a recession. But the unemployment rate will likely be one of the last data points to turn decidedly. The graph below demonstrates that the average unemployment rate usually turns up noticeably a couple of months into a contraction, as corporations acknowledge the slowing economy. For unemployment to follow the average recessionary path, the unemployment rate would eventually rise above 7 percent, and not top out until April of 2009. With that said, the eventual total job loss in the current downturn could be below-average because the expansion didn't create an above-average number of jobs. Non-farm payrolls have expanded at an average of a little over 8 percent during the 3-year periods prior to the end of expansions. In this cycle, payrolls grew at roughly half that rate.

Housing and Production

The charts above show that the trends in the employment data are in step with past recessions. Other data that track production and consumer data show similar patterns. Housing data is out of step. It turned down noticeably early, and to a larger degree than previous recessions. For example, housing starts normally begin to slow about a year prior to the beginning of a recession, and usually fall for about 9 months into a recession, for an average drop of 25 percent from peak-to-trough. During this cycle, housing starts peaked more than two years ago and have already fallen by more than 50 percent. In a typical recession, housing starts turn up about 8 to 9 months into the contraction.

On the bright side, the most severe drop in housing starts has typically been in the months just before a recession begins, with a slower pace of decline for a few more quarters until the absolute low. Though it's likely that housing will slow even further, the sharpest portion of the contraction may be behind us.

While some regional indexes that track production – Chicago being the most notable - have declined sharply the last few months, the ISM Production Index continues to straddle the line between expansion and contraction. That's not unusual. From its highs of last year, the recent declines in production mostly match the historical trends. The ISM Purchasing Managers Index (PMI) usually begins to slow about 6 to 8 months prior to the start of recession and doesn't bottom for another 7 months after a recession starts. Based on the average drop, the PMI could be about halfway through its overall decline.

Another index released by the ISM – the New Orders Index - tends to be an early mover. New orders eventually turn into production, inventory and sales, so the index can be an leading indicator of economic activity. The New Orders Index fell to 49.1 in February, which was the third consecutive month where order backlogs declined. This is in line with the average decline in new orders historically. Although it's a volatile measure, it may be one of the first measures to turn up. The New Orders index has bottomed about 6 months into recessions.

 

Earnings

Corporate earnings may end up providing the most interesting storyline. That's because earnings usually begin to roll over a few months after the start of a recession, and bottom a long 18 months following the economy's peak. But it looks like earnings peaked early, in the third quarter of last year because of heavy writedowns in the financial sector. That collapse in financial sector earnings, was influenced by the earlier-than-normal decline in the housing market.

The other sectors in the S&P 500 had positive earnings gains in the fourth quarter. Earnings at S&P 500 companies, ex-financials, were up 15 percent last quarter, according to Bloomberg data. It may be worthwhile to track these two components of earnings individually over the next few months. That's because corporate earnings - outside of financials – may be following their more traditional performance of peaking after the onset of a recession. That means that most of the declines in earnings may still be ahead.

Given that recent earnings growth has been far above historical norms because of record expansion in profit margins, the earnings outlook is going to depend on how well those margins weather an economic downturn. In any case, the enormous earnings rebound projected by analysts for the second-half of 2008 seems overly optimistic. If the path of earnings follows that of previous recessions, earnings aren't likely to bottom until mid-2009.

If the current downturn follows the typical course, housing starts, production, and new orders might begin to improve later this summer, while the employment and earnings may not improve until early or mid-2009.

Markets

If we assume the economy recently entered recession, the stock market has performed as would be expected. On average, the market peaks about six months prior to the start of a contraction and begins to decline more aggressively as the contraction begins. Based on the 9 previous recessions since 1953, the market bottomed an average of 6 to 7 months into the recession (the average recession has lasted 11 months). But this average masks a lot of variability. There have been important bear markets that lasted longer. The market bottomed 18 months after the beginning of the 2001 recession and 10 months after the start of the 1973 recession.

Given the variable length of recessions, we can examine the data from a different perspective. Instead of asking how long it takes for stock prices to bottom once a recession starts, we can ask how many months prior to the end of a recession do stock prices begin to advance from their lows.

The last graph below changes the reference point. The vertical black line shows the end of each recession. The blue line is the change in the S&P 500 two years before and after that point. Although the common rule of thumb is that markets bottom six to nine months prior to the economy turning up, the S&P 500 has actually bottomed closer to four or five months prior to the end of recessions. The market is a discounting mechanism. It's not clairvoyant.

The time-frames backed out of this analysis are intended to provide general perspective, not to provide specific points to expect turns or make investment decisions. There is too much variance in the length of recessions and the behavior of stocks to count on their average performance. But it's important to keep in mind that stock market declines triggered by the onset of a recession tend to be longer and the losses more severe than the results for the “average” bear market.


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