Recessions and the Stock Market
I’m sure it would surprise nobody if we said that recessions aren’t good for stocks and mutual funds. After all, a stock represents an ownership interest in a company and if that company is going to see less business during a recession, then investors will expect lower profits and put a lower value on the stock. For companies that are in precarious positions because of high levels of debt or the like, a recession can even spell the end if they are no longer able to keep up with their debt obligations.
Even investors with broad exposure to a number of stocks through mutual funds see declines during recessions as the market simply ends up pricing nearly everything down to compensate for additional risk in the environment. The big question, though, is how long-term investors should look at this situation.
Milking the downturn
For long-term fund investors, the fall in stock prices creates opportunity. Lower stock prices give good mutual fund managers the opportunity to buy more of the stocks that are down temporarily but will outperform over the longer term. Investors that add money, rather than pull money out, during a downturn are in a much better position to see outsized gains when the market eventually recovers. In fact, research has shown that the actual performance for most individual investors tends to fall below the performance of the funds that they invest in because they add money during “good times” and pull money out during the “bad times” — exactly the opposite of what they should do.
When to make your move
So the dilemma for many investors, then, is when to start putting in extra money. Shouldn’t they wait until the recession is over and try to get in right at the bottom as the economy is recovering? Well, actually, the answer is no, because the stock market anticipates turns in the economy and is quite good at it. Finance professor and author Jeremy Siegel notes:
The major determinants of stock prices are corporate earnings and interest rates. The stock market almost always falls before recessions. In fact, out of the forty-one recessions from 1802 through 1990, thirty-eight of them, or 93 percent, have been preceded or accompanied by declines of 8 percent or more in the stock returns index (the only exceptions were the 1829-30, 1945, and 1953 recessions). In the postwar period the peak of the stock market preceded the peak of the business cycle by between six and seven months.
Recent research by management firm Northern Trust paints a similar picture. Their numbers show that peaks in the stock market precede peaks in the economic cycle by anywhere from one to ten months. Similarly, troughs in the stock market precede troughs in a recession by two to eight months. In other words, by the time you realize that we’re in a recession, the market has already fallen, and if you wait for the “go ahead” that the recession is over and everything is peachy again, the stock market will already be well into its upswing.
The plan
The solution to this is two-fold. The first part is to make sure that you have a good investment strategy. This means making sure that you are adequately diversified and have put your money with high quality funds. Being overly reliant on a single fund or sector of the economy, or investing with low-quality funds can lead to trouble even without a recession — with one, it can be even worse.
The second part is to be aware of the fact that at the times when there’s the strongest urge to pull your money out of the market, it’s really the best time to be putting more money into the market — and vice versa. This, of course, can be easier said than done. While many people know this intellectually, it’s very easy to get overwhelmed by the fears du jour and not follow it when it counts. If you find adding extra money during down times to be overwhelmingly stomach churning and adding extra money during boom times very inviting, then the best solution is to simply have a steady amount that you put in on a regular basis, come rain or shine.
Downturns are a normal part of the long term cycles of the stock market, and are welcomed by many investors for the opportunities that they create. Investors that are able to keep a long term view in mind during downturns stand the best chance of bolstering, rather than harming, their portfolios during these periods.
