With negative returns in several asset classes and rumors of the Fed's interest rate campaign putting further pressure on the stock market, some economists are calling for a recession. But what does that actually mean?
A common definition of a recession is two consecutive quarters of declining GDP. Often, recessions are referred to more broadly as significant declines of economic activity lasting more than a few months.
When it comes to the future of your portfolio, it might not matter if we are officially in a recession. Unlike GDP, the stock market is forward looking. We have already experienced a drop in prices as investors have incorporated new information about inflation, the Fed, Ukraine, and beyond. Buyers and sellers are reflecting their expectations about future cash flows, including any impact of an economic downturn, into their trades.
While a recession is certainly no walk in the park, it doesn't mean that your portfolio is doomed. Data covering the past century's 15 US recessions before 2020 show that investors tend to be rewarded for sticking with equities. In 11 of the 15 instances, returns on stocks were positive two years after the recession began. The annualized market return for the two years following a recession's start averaged 7.8%.1
Most recently, we experienced the shortest recession in the past 100 years during early 2020. The US stock market tumbled more than 20% as investors dealt with uncertainty during the pandemic. However, investors who stuck with stocks experienced the sharp rebound and experienced a 24.1% gain for the year. (Market Returns Through a History of Recessions) This is also a reminder that intra-year declines don’t necessitate that your portfolio will be down by the end of the year.2
'Bear Market' is another piece of lingo that you might be hearing about lately. While a recession usually refers to the economy, bear markets describe markets specifically. From 1926-2021, the S&P 500 Index experienced 17 bear markets, or a fall of at least 20% from a previous peak. The average length of a bear market was around 10 months.3 While that many bear markets may sound daunting, the S&P 500 Index still returned an annualized 10.46% in that same period. Put another way, a dollar invested in the S&P 500 Index on 1/1/1926 would have grown to over $14,000 by the end of 2021.
Historically, US equity returns following sharp downturns, have, on average, been positive. The below exhibit illustrates that going back to 1926, US equities have tended to deliver positive returns over 1-, 3-, and 5-year periods. On average, the broad market index returned 22.2% one year following a 20% market decline. Sticking with your plan helps put you in the best position to capture the recovery.4
It's human nature to try to identify patterns, but stock returns are volatile and unpredictable. The article Don't Let Talk of Market Cycles Take You for a Ride, finds that one period's stock returns tells you almost nothing about the next. While we can't predict the future, we can gain insights from the past. Nearly a century of bull and bear markets shows that the good times have outshined the bad times.
It can also be human nature to take action (or make a transaction). But emotional reactions and investment decisions are sort of like mixing your mayonnaise with your yogurt – just because you can, doesn’t mean that you should. Selling after prices have already dropped can lead to missing out on the potential gains.
You probably can’t control what the Fed does or what happens to a sector’s profits. Rather, you can control how you react. The future is uncertain. Fortunately, lessons learned from the past should bring comfort to those who stick to their plan.