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Fear: The Media’s Best Friend but an Investor’s Worst Enemy
Does a recession mean the stock market will crash?
Here's what might be the most damaging sub-genre of the “Are we in a recession headline” that the media shoves in our faces every day:
“Here’s how to invest your money for the upcoming recession”
I roll my eyes at these types of articles for three reasons.
It presumes that we are currently in or are about to head into a recession
The writer is suggesting they have a secret trading strategy that will save you from the market crash
It presumes that an economic recession will definitely cause the stock market to crash.
We can throw the first two points out the window.
Even top economists and investment managers fail to accurately forecast economic recessions and market crashes. So, we can safely assume the clickbait artists have no idea when these things will happen either.
But, the question of whether an economic recession will lead to a market crash is interesting. To many, whether a recession means impending losses in the stock market is like asking, “Is water wet?”
The truth might surprise you.
In years with an economic recession, the S&P 500 has only fallen by 1% on average.
When markets do decline in years of recession, those declines are often short-lived.
Some of the best returns you’ll ever see in the stock market come the year after a market crash.
If you’re properly diversified and aren’t retiring anytime soon, ignore doom and gloom headlines about possible looming recessions.
Read to the end of this article to learn how the stock market has performed in every recession since 1945 and how the stock market and the economy are connected.
The stock market does surprisingly well in recessions
In years with a recession, the S&P 500 lost only 1% on average.
That’s the headline finding from research from CFRA. Here’s how the U.S. market performed in years with a recession and the years following a recession dating back to 1945.
There are two critical points to understand from this chart.
The market had positive returns in about half of all recessions since World War 2.
In years following recessions, the market returned 16.9% on average.
Recessions don’t always mean the stock market will crash—and even if it does, it tends to rebound in the following year.
Yes, there are some terrible years where recessions have led to major market declines. The 2008 recession was especially painful, losing nearly 39% in a single year. But the 2008 recession was historically large, and the market rebounded by almost 24% un in the following year.
Amazingly, the stock market has provided exceptional returns during years of recession. The S&P 500 was up nearly 17% in 2020 during one of the deepest—if short-lived—recessions since the great depression.
The complicated relationship between the stock market and the economy
In The Investor’s Mindset (publishing August 8th), I dedicate an entire chapter to discussing how important it is to understand that the stock market is not the economy.
From an investor’s perspective, one of the key differences to keep in mind is that economic data is backward-looking, and stock prices are forward-looking.
When you hear a GDP report, that data is likely several months old, whereas the price of any stock today is based on how much money investors believe that company will earn in the future. Stocks tend to price in bad economic data before it gets reported on the news.
It’s not that stock prices are immune from bad news in the economy; it’s that investors often price in bad news before it’s officially reported.
If economists release a report that says the unemployment rate has gone up, that does not mean the stock market will necessarily fall on that news.
The unemployment statistic uses data that could be a month old.
A month ago, companies, analysts, and investors would have been aware that the unemployment rate was going up—after all, these were the companies laying people off—and that fact would already be reflected in stock prices.
Think about what happened in 2020.
When it became clear that COVID-19 was going to spread to every corner of the world, the S&P 500 dropped 32% in five weeks. This all happened before we were fully locked down in North America in March 2020.
The market bottomed on March 20th and went on a historic run for the rest of 2020, increasing 63% from its bottom. Some of the best returns in the history of the S&P 500 were taking place at the exact same time we were receiving the worst GDP and unemployment numbers in a century.
Remember, stock prices are forward-looking and economic data is backward looking.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.