The Dreaded "R" Word

The odds have grown that the economy will slip into a recession. At the beginning of last year, many economists put that chance at less than 1-in-3; now an increasing number says it has climbed to around 50-50. Goldman Sachs, the biggest investment bank on Wall Street even thinks a recession is inevitable this year. For its part, the Federal Reserve is not calling for a recession. It’s often repeated that economists have predicted 20 of the last 10 recessions. This is probably true to a certain extent given that many prominent economists have been calling for a recession every year since 2004.

Nobody has a crystal ball, but history provides at least some clues as to how the market might behave if we do see a recession.

Stocks and Recessions:

The 90-91 recession probably looks the most like today – a bad housing market accompanied by bad loans hurting banks and a pro-active Fed cutting rates even before the recession began. In the three recessions between 1980 and 1991, market performance was the ugliest prior to the recession when investors panicked about the effects of a downturn in earnings.

The 2001 recession was caused by a combination of high stock-price valuations and a huge decline in corporate earnings. Prior to the 2001 recession, the P/E ratio hit an all-time high of 46 times earnings. This is encouraging given that the trailing P/E is currently about 16. At current price levels, it would take an earnings decline of 65% to achieve a P/E of 46 again. Additionally, sharp declines in earnings always have been temporary, caused by recessions or other special circumstances, and earnings as well as stock prices have rebounded subsequently. The average return in the 6 months following each recession since 1969 is 11.7%. Professional economists can’t even predict the start of a recession accurately let alone it’s length and severity. The best course of action, as always, is to stick to a carefully considered asset allocation plan. Even a seasoned trader like James Cramer will tell you that the only free lunch in the stock market is a well-diversified portfolio.