A few weeks ago, the big debate on Wall Street was whether or not the economy was headed for a recession.
Today, for many investors, the question isn't whether a recession is coming, but when. In fact, some are wondering whether one has already begun.
Does the timing of a recession really matter? If you're an equity investor, it does.
No matter how aggressively the US Federal Reserve lowers interest rates, the economy may be headed for a severe downturn.
The stock market, at least, seems to support this argument. Just three weeks into the new year, the Standard & Poor's 500-stock index is down nearly 10 percent. And since the market peaked on Oct. 9, stocks have lost more than 15 percent of their value.
So, the thinking goes, the sooner an official recession is declared, the sooner the economy can start to work its way out of it.
"If we are in fact in recession, we may be close to fleshing out a bottom here in stock prices," said Duncan W. Richardson, chief equity investment officer at Eaton Vance, an asset management firm.
Moreover, recent history shows that it's often the anticipation of a recession that depresses stock prices, not the actual experience of a recession. So if we're out of the anticipatory stage, stocks could soon start to stabilize.
Sam Stovall, chief investment strategist at S&P, studied the performance of the stock market during the last 11 recessions, as defined by the National Bureau of Economic Research, going back to 1945. He found that the S&P 500 fell 26 percent, on average, from the months leading up to a recession to the recession lows.
Yet Stovall's analysis also showed that between the official starting and ending dates of those recessions, the S&P held relatively steady, gaining 0.1 percent, on average.
To be sure, this wasn't always the case. In the most recent recession, from March to November 2001, stocks tumbled by about 8 percent. And in the severe recession that ran from November 1973 to March 1975, the S&P lost nearly a quarter of its value.
Moreover, the early stages of recessions generally aren't smooth sailing. A separate study of stocks and recessions by Ned Davis Research showed that equity prices tend to drop nearly 5 percent in the first six months of contractions.
But the typical recession since World War II has lasted 10 months, on average, the National Bureau of Economic Research said. And over those entire periods, stocks have historically held their ground.
Why is this important? Well, some economists think that the economy is already in a recession. Earlier this month, Merrill Lynch economist David Rosenberg said that recent employment data suggested the economy might have slipped into a recession at the end of last year. If it did, that could turn out to be reasonably good news for the equity markets now.
Keep in mind that in three of the last four recessions, stocks didn't simply hold steady -- they actually gained ground. In the recession from July 1990 to March 1991, for instance, the S&P 500 rose 2.5 percent, despite a severe sell-off in the summer of 1990. And in the recession from January to July of 1980, stocks climbed nearly 6 percent.
There is something else to consider. If the economy is already in recession, the Fed will probably have more impetus to cut short-term interest rates to fuel economic activity. As Nick Raich, director of equity research at the National City Private Client Group in Cleveland, said: "If the Fed is going to get aggressive from here, it could give a boost to stocks later in the year."
Aggressive rate cuts could also shorten the duration or severity of a slowdown.
In most cases, stocks tend to rebound as the economy emerges from a recession. The S&P study found that after 10 of the last 11 recessions, stocks soared in the ensuing six months. On average, the S&P index gained 12.1 percent.
If you measure the market's performance from recession lows, rebounds are even more compelling. Ned Davis Research looked at the last 10 recessions and found that stocks rose 24 percent, on average, in the six months after hitting a recession low. That is why Tim Hayes, chief investment strategist at Ned Davis, said that while a recession could continue to pressure the stock market, "it could also lead to a great buying opportunity."
Of course, there are no guarantees that the market will hit bottom in the middle of this slowdown. For instance, after the last recession ended in November 2001, stocks fell 18 percent over the next 12 months.
Still, there are reasons to believe that this will not be a repeat of the bear market of 2000 to 2002. For starters, Stovall said: "Valuations in the market lead me to believe that this market decline will end up being either a correction or a very light bear market." Although the price-to-earnings ratio of the S&P 500 approached 40 in the final stages of the 2001 recession, the ratio today is only around half of that, indicating that stocks aren't nearly as pricey.
Moreover, Raich said that while profits were likely to take a hit in an actual recession, the weakness in earnings in the third and fourth quarters of last year would make for relatively favorable comparisons in the second half of this year.
"So there are some bright spots for the market," he said. "They're just being overshadowed right now by all this recession talk."
Paul Lim is a senior editor at Money magazine.
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