Recessions usually crush shares – but investors can always reduce their ravages

Chris Leithner

Leithner & Company Ltd

According to Ashley Owen (“Recessions Are Usually Good for Sharemarkets,” Firstlinks, 12 October), “history shows that economic contractions have been mostly good for share prices.” Specifically, “the Australian share market has actually increased during the majority of economic recessions in Australia. The same is true for the U.S. share market during U.S. recessions.” In addition to these startling claims, Owen strongly implies an even more astonishing one: investors can foresee the start of recessions.

If he’s correct, then he’s discovered two things that everybody else has apparently overlooked – and will surely revolutionise investing. For if recessions really are “mostly good” for shares, and if investors can consistently anticipate recessions, then they can benefit from them; and if investors can profit from recessions, they shouldn’t fear them. Quite the contrary, and as a matter of urgency, they should demand that policymakers induce them!

But Owen isn’t correct: he’s demonstrably mistaken. Indeed, in crucial respects, the truth is the polar opposite of what he purports to find. Owen doesn’t analyse (or if so, doesn’t present his results of) American data. My analysis, which merges the dates of recessions determined by the U.S. National Bureau of Economic Research into share market data compiled by Robert Shiller, comprehensively refutes his claims:

During two-thirds of the recessions in the U.S. over the past 150 years, 80% of those whose duration is 12 months or more – and 100% of them since 2000 – the S&P 500 Index has fallen. The vast majority of American recessions, in short, have been bad – and all recent ones have been very bad – for the Index. Moreover, as I also show, investors cannot reliably anticipate U.S. recessions.

What about Australia? Owen doesn’t tell us the source of his data. He also neglects the fact that until recent decades and as the RBA’s Bulletin observed not long ago, this country’s economic statistics have been insufficiently broad, deep, valid and reliable to demarcate the beginning and end dates of recessions with anything like the NBER’s precision in the U.S.

For these reasons, I strongly question Owen’s principal claim. But even if Australian recessions aren’t bad for Australian shares, I demonstrate that American ones certainly are. In other words, recessions in the U.S. don’t just cause the S&P 500 to tank: they do the same to major Australian equity indexes.

From the point of view of the two countries’ equity returns, my analysis thereby corroborates the aphorism “when America sneezes, Australia catches a cold.” Using a new series of historical Australian stock market data compiled by the RBA, I show that recessions in the U.S. have usually caused the prices of Australian stocks to fall – often greatly. And as in the U.S., so too here: longer American recessions cause bigger losses in Australia. Worst of all, over time the harmful influence of American recessions upon Australian stocks has worsened. The implication is clear and fundamental:

If past is prologue, when the U.S. falls into recession – as it certainly will at some point, and whether or not Australia does likewise – Australian equity indexes will probably tumble.

Australians are neglecting this crucial result. According to Shane Oliver’s guide to riding out a “year to forget” (28 October), for example, “he … expects Australian shares to deliver a positive return in 2023 … The other piece of good news is that Shane believes Australia can plot a different course to many other economies. For example, he believes the chance of recession in Europe is 80%. (In) the U.S. it is a 50/50 call but in Australia, the chance is only 40%.”

I suspect that Oliver is overly sanguine. (He certainly was last year. On 14 December 2021 he stated: “continuing solid economic growth, rising profits and still easy monetary conditions should result in good overall investment returns in 2022, but they are likely to be more constrained and volatile than in 2021.”) His latest expectations are inconsistent and require significant qualification. He’s correct that the correlation of Australia’s and other countries’ key macroeconomic aggregates such as GDP is low and intermittent. In plain English, just because the U.S. succumbs to recession doesn’t mean that Australia will. But he overlooks a key fact that my analysis highlights: the correlation of American and Australian stock market returns is positive and strong.

If Oliver is correct that the probability of a recession in the U.S. next year is 50%, then there’s a significant (50% × ca. 80% ≈ 40%) chance that major Australian equity indexes will be lower than they are presently.

There is, however, good news. Although neither economists nor investors can predict recessions, investors can substantially lessen slumps’ injurious effects on their portfolios. I outline the gist of the tried-and-true means which Leithner & Company has successfully used since 1999 to mitigate recessions’ ravages.

Recessions in the U.S. Usually Cause American Equities to Fall – Often Heavily

Before we advance into the thickets, let’s clarify the land’s basic contours:

Recessions typically clobber investors’ returns; they also cause returns to fluctuate much more than usual. They reliably generate what most investors dread most: losses and volatility.

Using the start and end dates of recessions established by the U.S. National Bureau of Economic Research (of which more below), Table 1 quantifies the frequency and duration of recessions in the U.S. since 1871. Merging these data to financial data compiled by Robert Shiller, Table 2 compares the Standard & Poor’s 500 Index’s month-to-month nominal returns and their fluctuations for (1) all months, (2) months during recessions and (3) months outside recessions since 1871, 1945 and 2000. 

Why these intervals? The longest one uses all available data. The second one (since 1945) excludes the Great Depression, the “Depression with the Depression” of 1937-1938, etc. Why exclude them? Some people insist, not implausibly, that the enormous growth of governments’ fiscal, monetary and regulatory interventions since the 1930s makes a repetition of that decade virtually impossible. Yet they almost invariably neglect to add, as James Grant detailed in his masterful The Trouble with Prosperity: A Contrarian’s Tale of Boom, Bust and Speculation (Random House, 1996) that governments’ increasingly crazed fiscal, monetary and regulatory interventions over the past few decades make healthy and sustainable growth a thing of the past – and also make financial crises like the GFC, and inflationary recessions like those of the 1970s, more likely.

Table 1: Frequency and Duration of Recessions in the U.S.

Why distinguish the months since January 2000? Many of this article’s readers will possess direct experiences and personal recollections of the recession of the early-2000s (and the Dot Com Bust), GFC and Global Viral Crisis. Another reason, as we’ll see, is that their effects upon investors were among the worst since the Great Depression.

A third reason is that Western economies are more lethargic now than they’ve been in decades – and a growing and now large number of economists, not just the usual cacophony of grouches and scrooges, are warning that the risk of a severe slump is significant and even likely. If one arrives, and if it resembles the most recent ones, it’ll be severe. (On the other hand, economists are unable to reliably foresee recessions; so the fact that many economists are presently predicting a slump is a good reason to doubt them.)

Regardless of the interval, during recessions the S&P 500 Index’s average month-to-month return has been negative, and during months outside of recessions it’s been positive (Table 2). Moreover, during recessions the monthly returns have fluctuated greatly (standard deviation of 5.2-7.0%) whereas during non-recessionary periods they’ve fluctuated only half as much (standard deviation of 3.0-3.4%).

Table 2: Monthly Nominal Returns, S&P 500 Index, January 1871-September 2022

During recessionary months since 1871, the Index has sagged at an average rate of 0.67% per month. During these 151 years, according to the NBER, the average recession has lasted 17 months; accordingly, by this criterion recessions have caused the Index to decrease, on average, by (1- 0.0067)17 ≈ 11%.

Yet in two senses the news for today’s investors, at least superficially, is good. First, Table 1 indicates that over time recessions have occurred ever less frequently: largely, I suspect, as a consequence of the enormous rise of government expenditure (“automatic stabilisers”), which gooses GDP, the proportion of recessionary months has fallen from almost three in 10 since 1871 to little more than one in 10 since 2000. Secondly, over time the average recession’s duration has fallen from 17 months to 13 months, i.e., by almost one-quarter. 

The very bad news, however, is that James Grant has been proved right. Like the environmental activists, local councils and others who refuse to permit local burn-offs, and thereby facilitate the accumulation of the detritus that causes the eventual conflagrations that destroy large areas of bushland and quantities of wildlife, so too central banks and governments: their refusal (through their interventions that suffocate market forces) to allow minor downturns have caused the enormous accretions of “malinvestments” which have erupted into major crises and severe recessions.

Since 2000, recessions have become much more lethal to investors: during this century’s months within its recessions’ start and end dates, the Index has plunged a gut-churning average of 2.21% per month. Accordingly, this century’s three (so far!) recessions have caused the S&P 500 to plunge an average of (1- 0.0221)13 ≈ 25%. And although this century’s recessions have been much shorter than those in the 1930s, on an annualised basis their losses in the U.S are comparable (see Table 3) and in Australia are even worse (Table 7). Recession, in short, have meant bear market.

Recall Owen’s startling conclusion: “economic contractions have been mostly good for share prices and the Australian share market has actually increased during the majority of economic recessions in Australia. The same is true for the U.S. share market during U.S. recessions.” Table 2 overturns this passage’s second sentence; Table 3, which expresses the S&P 500’s returns during recessions as CAGRs in both nominal and “real” (CPI-adjusted) terms, refutes it comprehensively.

Table 3: Average Compound Annual Growth Rates, S&P 500 Index, Nominal and CPI-Adjusted, during Recessions

If Owen were correct, then the CAGRs in Table 3 would be mostly positive. But they aren’t: without exception, they’re all negative. If Owen were right, then the figures in columns labelled “percentage of recessions with negative CAGR” should be well below 50%; yet with just one exception they’re all well above this threshold – and as often as not, 100%. Whether in the 19th, 20th or 21st centuries, and whether they’re short or long, mild or severe, recessions in the U.S. have usually caused losses – and often severe losses that take years to recoup.

Two Sources of U.S. Data

The foregoing results, as well as those in the remainder of this article, rely upon:

  1. Definitions of business cycles and resultant identification of recessions by the National Bureau of Economic Research (NBER);
  2. Data compiled by Robert Shiller for his book Irrational Exuberance (Princeton University Press, 1st ed., 2001).

There’s no more respected arbiter of business cycles and the start and end dates of recessions in the U.S. than the NBER; and there are no more valid and reliable data of the S&P’s level, etc., and hence its returns, etc., since 1871, than Shiller’s. 

Founded in 1920, the National Bureau of Economic Research (NBER) is an American private non-profit research organisation “committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.” It’s probably best known as the provider (and since the 1960s has been the quasi-official arbiter) of start and end dates of economic cycles – and thus recessions – in the U.S.

Robert Shiller is an American economist who since 1982 has taught and researched at Yale University. Since 1982 he’s been an associate of the NBER, and since 2008 has ranked among the world’s 100 most influential economists. In 2013, he (together with Eugene Fama and Lars Peter Hansen) jointly received the Bank of Sweden Memorial Prize in Economic Sciences in Memory of Alfred Nobel (commonly but mistakenly called the “Nobel Prize in Economics”) for their “empirical analysis of asset prices.”

What Is a Recession?

My definition is simple: “a recession is what the NBER says it is; and a given recession starts and ends when the NBER says so.” A recession, according to the NBER,

is the period between a peak of economic activity and its subsequent trough, or lowest point. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief. However, the time that it takes for the economy to return to its previous peak level of activity or its previous trend path may be quite extended.

Like reclusive species of wildlife, a recession’s start and end dates aren’t easy to spot. A recession “involves a significant decline in economic activity that is spread across the economy and lasts more than a few months. In our interpretation of this definition, we treat the three criteria—depth, diffusion, and duration—as somewhat interchangeable. That is, while each criterion needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another.”

If that isn’t clear-cut, it’s because the real world is innately messy. What’s evident is that recession isn’t merely – or even primarily – two consecutive negative quarters of Gross Domestic Product.

Most of the recessions identified by the NBER include this criterion. Crucially, however, the start of a recession can precede or follow GDP’s first negative quarter; similarly, its end can precede or follow the final quarter of negative growth. As a result, (a) a recession’s start and end dates and (b) periods of negative GDP growth often don’t coincide. That’s likely one reason why (in addition to his lack of suitable data) Owen’s results in Australia differ diametrically from mine for the U.S.

Ultimately and unavoidably, to a significant extent the NBER’s determinations are subjective. “The determination of the months of peaks and troughs,” it says, “is based on a range of monthly measures of aggregate real economic activity published by federal statistical agencies … There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions. In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.”

For reasons I’ll elaborate in the next section, the NBER makes a final crucial point:

The committee’s approach to determining the dates of turning points is retrospective. In making its peak and trough announcements, it waits until sufficient data are available to avoid the need for major revisions to the business cycle chronology. In determining the date of a peak in activity, it waits until it is confident that a recession has occurred … As a result, the committee tends to wait to identify a peak until a number of months after it has actually occurred. Similarly, in determining the date of a trough, the committee waits until it is confident that an expansion is underway.

Do Investors Accurately Foresee Recessions?

Ashley Owen implies that they do: “share prices start falling in anticipation of profits falling in an upcoming economic slowdown ...” If he’s correct, then in the months (he doesn’t specify how many) before a recession, shares’ prices will decrease – and hence investors’ month-to-month returns will be negative. Is this true?

Figure 1 demonstrates that it isn’t. During the six months (-6 to -1 on its horizontal axis) before (a) all recessions over the past 150 years, (b) recessions of 12 months or greater duration since 1871 and (c) all recessions since 1945, month-to-month returns on the S&P 500 have been positive – that is, the Index has on average been rising. In the month the recession commenced (month 0) and the six months thereafter (1-6), in contrast, average returns were invariably negative, and usually greatly so; hence the Index plunged. The same is true of all recessions of 12 months or more, and of all recessions since 1945 (and of recessions before 1945, but for the sake of legibility I’ve omitted that series from the graph.)

Figure 1: Month-to-Month Returns, S&P 500 Index, Six Months Before and After the Start of Recessions

In short, there’s no evidence that investors have anticipated the onset of recessions – and compelling evidence that they haven’t.

We’re now in a position to appreciate the full significance of the point that the NBER’s approach to determining the beginning and end dates of recessions is retrospective. With that point in mind, I inject a comment and offer another (albeit speculative) explanation of the results in Figure 1. For a century, albeit through their brokers until the 1990s, Americans have possessed access to “live” stock market data. But until very recently, they (and the NBER) lacked timely access to corresponding economic numbers. Is the economy expanding, flat-lining or contracting? By how much? Figuratively speaking, policymakers as well as investors were flying blind and had to grope their way through the dark. It’s therefore hardly surprising that investors were unable to anticipate major turning points in the business cycle – and, as in the months before the Great Depression, pushed markets greatly higher before plunging off the cliff.

Today, anybody who wants them can access “live” (or nearly so) economic data. Yet the present – never mind the future – is for all practical purposes just as opaque as it was in previous decades. Notice in particular that since 1945 investors have been even blinder than their forebears in the two months preceding the start of a recession. How then, to interpret the results in Figure 1?

Before the fact, investors and economists cannot accurately anticipate the onset of recessions. Retrospectively, I wonder whether NBER uses (or once used) plunging markets as one of its inputs to mark the start of recessions.

Do Investors Accurately Anticipate the Ends of Recessions?

Owen implies that they do. He states: “share prices start rebounding ... in the middle of a recession ...” Recall from Table 1 that since 1871 the average recession in the U.S. has lasted 17 months. I’ll round this to 18; accordingly, the average recession’s first half comprises months 1-9, its mid-point is between months 9 and 10, and its second half is months 10-18. During its second half, do share prices tend to rebound?

Figure 2: Month-to-Month Returns, S&P 500 Index, Before and After End of Recessions

Figure 2 demonstrates that they don’t – yet Owen has a point. During the nine months (-9 to -1 on its horizontal axis) before the end of recessions over the past 150 years, as well as those before and since 1945, the S&P 500’s month-to-month returns were mostly negative – that is, the Index was mostly decreasing – yet its falls decelerated as recessions’ ends neared. In their final two months (-2 and -1) returns became positive, and have been particularly positive in recessions since 1945. Returns remained positive during the next seven months (0, which marks the month the recession ends, and the first six months after the recession). Much the same is true of recessions of 12 months or more, etc.; again, for the sake of legibility I’ve omitted these series from the graph.

Does Figure 2 provide evidence that investors reliably anticipate the ends of recessions? It’s possible, but I ‘m sceptical. For if investors demonstrably cannot discern the start of recessions, why should they be able to foresee their end? Investors certainly lack a reliable crystal ball; for decades, however (I’m assuming roughly since 1945), they’ve possessed one crucial piece of information that their forebears lacked: knowledge of the average length of a recession as established by the NBER. Given this information, investors as a whole might reckon: “a recession normally lasts 18 months, and the market’s been in a funk for more than a year; so the end of this recession is probably nigh.”

Finally, just as it might incorporate investors’ behaviour (namely plunging stock markets) into their decision to mark the start of a recession, the NBER might regard rising markets as an indicator that its end is approaching.

A New Series of Australian Historical Market Data

I doubt whether Australian data measuring economic conditions before the 1960s (Owen analyses them from the 1890s) are broad, deep, valid and reliable enough to sustain his claims. That’s not a criticism of the academics and civil servants who, beginning in the 1950s, began to compile these data: they possessed very limited means, and the raw materials available to them were (and to us remain) scanty. Thomas Mathews (“The Australian Equity Market over the Past Century,” RBA Bulletin, June 2019) has aptly summarised the crux of the matter:

… Historical data for Australia are somewhat limited (Chris interjects: that’s an understatement; compared to the U.S., they’re VERY limited). Many time series begin in the 1980s or 1990s … Additionally, several existing equity market time series do not extend far enough back to cover a period of economic recession, limiting our ability to interpret how they might react if one happened in the future. In contrast, in countries (such as the U.S.) where comprehensive data do exist, long-run comparisons can be informative.

Mathews has assembled a new (and improved vis-à-vis its predecessors) time series of Australian equity prices. These data have been constructed primarily from stock gazettes published by the Sydney Stock Exchange, one of the predecessors of the Australian Securities Exchange, and aggregate quarterly company-level data from 1917 to 2019 (I’ve extended the relevant series to 2022) on a range of variables of interest.

Significantly, all of these variables relate to stocks, and none of them to the macro-economy. To this day, here’s nothing in this country remotely comparable to the NBER – and the breadth and depth of the data it uses to determine the start and endpoints of recessions. Even in the U.S., this determination is difficult and subjective; in this country, it’s currently even more so, and historically was insuperably so.

These equity market data, together with details about their collection and limitations, appear in Mathews’ article and associated Discussion Paper on the RBA’s web site.

When America Sneezes, Australia Does Indeed Catch Cold

How, then, to investigate the impact over long intervals of recessions upon Australian stocks? I’ve merged the dates of U.S. recessions as established by the NBER into the Australian equity index data compiled by Mathews. Table 4 compares the index’s quarter-to-quarter nominal total returns and their fluctuations for (1) all months, (2) months during recessions and (3) months outside recessions since 1917, 1945 and 2000.

American and Australian returns are inexactly comparable. The American ones are capital-only (that is, exclude dividends) and derive from monthly observations since 1871; Australian returns are total (that is, include dividends) and derive from quarterly observations since 1917. Nonetheless, their commonalities are striking.

As in the U.S., so too in Oz: regardless of the interval, during American recessions Australian stocks’ average quarter-to-quarter return has been negative, and during months outside of recessions in the U.S. the Australian quarterly return has, on average, been positive. Notice in particular that Aussie stocks’ performance during American recessions since 2000 is worse than in recessions since 1945, which in turn is worse than in American recessions since 1917: this implies that the influence of American recessions upon Australian stocks is high and rising.

Australian and U.S. stock market returns share another key feature: during American recessions the returns of Australian stocks have been relatively volatile (standard deviations of 10.1-11.4%) whereas during non-recessionary periods they’ve fluctuated much less (standard deviations of 5.4-7.3%).

Table 4: Australian Equities, Quarterly Total Returns, Nominal, March 1917-September 2022

According to Owen, “economic contractions (in Australia) have been mostly good for share prices and the Australian share market has actually increased during the majority of economic recessions in Australia.” Even if that were true, which I doubt given (1) its innate implausibility, (2) the lack of suitable economic data and (3) its utter inconsistency with reality in the U.S., it must be paired with a firmly-grounded countervailing fact: when America sneezes, Australia catches cold.

Table 5: Australian Equities’ Returns during U.S. Recessions, Average Compound Annual Growth Rates, Nominal and CPI-Adjusted