Is A Recession Coming & Is The Stock Market Going to Crash?
Updated: Aug 21, 2022
2022 will go down in history as one of the toughest years for investors. We started the year worrying about inflation. Then the US Federal Reserve came in to hammer the markets further with an aggressive rate hike plan after realizing they are behind the curve. But that is not really surprising because they are almost always late to the party.
For the first half of the year, practically everything other than commodities dived. The focus then shifted to the increasing likelihood of a recession and we start to see safe-haven assets such as US Treasuries rebounding. In fact, stocks also reversed course from their low in June in the face of retreating commodity prices and reduced inflation expectations. The latest Consumer Price Index (CPI) print for the month of July 2022, which comes in lower than expected, affirms what the market thinks and sent stocks on a euphoric rise.
So, a key question tugging at many investors’ minds is this – Is a recession really coming?
What the Bond Market Is Saying
If you look at the bond market, the answer seems pretty much a yes. The US Treasury yield curve has gone inverted since early July 2022 with both 10Y-2Y and the 10Y-1Y spreads dipping into the negative zone. Since the 1950s, a recession has always occurred, except for one, between 8 to 18 months following a yield curve inversion. Thus, if history holds, then we can be looking at one as early as next year. But even if a recession does unfold, we have no idea how shallow or how severe it will be.
What the Stock Market Is Saying
But the stock market seems to paint a different picture and is behaving as if the worst is behind us. A severe recession is definitely not on their cards at the moment. The stock market went up across the board since the middle of June and NASDAQ Composite rose more than 20% from its low. From a technical definition, at least for NASDAQ Composite, it is back in the bulls.
And the Volatility Index (VIX), the fear gauge, fell and touched below 20 briefly and is now playing around that level, something we don't get to see much this year.
Now, both markets are forward-looking. So who is right?
My Inclination - Go With The Bond Markets
Personally, I am more inclined to believe what the bond market is telling us. Because historically, the US Treasury yield curve has been a pretty reliable indicator when it comes to gauging the economy. And the majority of those who invest in US Treasuries are institutions with the necessary expertise and resources rather than retail players. The stock market, on the other hand, often contains too much noise.
But even if a recession does materialize, does it mean the stock market will start crashing again? I don't have a crystal ball but we can take references from past recessions and see how the stock market behaved during these episodes.
Past Recessions & The Stock Market
A recession is a state of the economy. It reflects what occurred in the past and these economic data are delayed. For example, you will only get the final current quarter's GDP number at the end of the next quarter. And GDP is only one of the inputs used by economists in the National Bureau of Economic Research (NBER) to determine if a recession indeed occurs. While I do not know exactly the criteria they use, labor market data and manufacturing activities are definitely part of the equation. Therefore, recessions are officially declared retroactively after it has passed months later.
The stock market, on the other hand, looks ahead. The prices of the stocks you see trading today reflect not just what transpired till now, but also what the market participants expect to happen in the future. So, with that in mind, let's look at what happened during the recession periods recognized by NBER since the 1950s.
1. Stock market moves up almost half the time during recessions.
As you can see, the Gross Domestic Product (GDP) does not always contract during the officially recognized recession periods. It can be a soft scenario of slowing growth amidst other factors happening. Neither does the stock market always head south. In fact, it moved up almost half the time. If you are new to the financial markets, this may seem baffling. We are in a recession and yet the stock market is up? However, if you consider the fact that markets look ahead, then this is absolutely possible. The stock market is not oblivious to a deteriorating economy here. What happened is that most of the time it reacts before the recession even starts or ends. So the start and end of a stock market's fall do not have to coincide exactly with the recession dates.
2. Stock market began its drawdown on average 6 months before the recession starts
In the past 11 recessions since 1950, the stock market has on average begun its downward move 6 months before the recession starts. With the exception of the recession from January 1980 to July 1980, the stock market made its move either on time or ahead of time.
3. Stock market bottomed on average 3 months before the recession ends
It should be no surprise here as well to know that the stock market tends to bottom before the recession is officially declared over. And based on history, it is ahead on average by around 3 months. The only time the stock market lags is during the dot com bubble period in 2001 when it hit the trough 11 months after the recession ends.
4. Stock market takes around 13.5 months to bottom and loses an average of 30.8% from the peak
The stock market experience losses of about 31% over a period of around 13.5 months on average from its peak to trough. While losses can run as deeply as more than 50%, it is also interesting to note that some are fairly mild, nowhere near to being considered a bear market. And a few brewed over in double quick time. For example, the stock market crash during the Covid-19 pandemic in 2020 is over in just a month or so.
Where Are We Today & Are We Out Of The Woods?
As data suggests, even if we do move into a recession, it does not necessarily mean the stock market will crash to new lows again. So is it safe to go all out into stocks? A lot will hinge on whether the stock market participants are being overly optimistic about what is going to unfold. Personally, my investment philosophy and strategy does not rely on picking tops and bottoms. But on my end, I don't think we are out of the woods yet . Why?
1. The current drawdown is still fairly short and mild.
Among the stock market crashes since 1950, the 2008-2009 Great Financial Crisis suffered the worst drawdown while the 2001-2002 Dot Com Bubble took the longest to bottom out. So if we take this two as the reference boundary, the current drawdown we are in now still looks fairly mild both in terms of magnitude and duration. Yes, each crisis is different and there have been even more "gentle" drawdowns in the past. But that alone, will not be enough to justify discounting the risks of potentially more adverse scenarios.
2. The long-term trend is still pointing down.
From a technical perspective, the S&P 500 still trades below its 200D MA even though it is closing in. And as far as the moving average suggests, the longer-term trend is still pointing downwards.
3. Inflation has come down but it is not there yet
And in the macro backdrop, inflation remains elevated. Yes, it has come down faster than expected which is a good start. Commodity prices also did retreat and the inflation breakeven rates are also coming down. But the fact is inflation is still way above the Fed's comfort zone and we have yet to see a more broad-based slowdown of inflation across different items and services. The drop in July's number was largely attributed to the fall in oil and gasoline prices. Other key areas such as food, shelter, and medical care actually rose albeit slower than in June. It would be premature to think the Fed would slow down and be into cutting rates as early as next year. Sudden lockdowns from China which can exacerbate supply issues, as well as the Russia-Ukraine conflict, also continue to pose a challenge. And while a stronger than expected economy as suggested by recent data seems good, however, that in itself can become a fuel for inflation and make it stickier than it should be.
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