By Investment Associate Bobby Adusumilli, CFA.
One common discussion topic with our clients recently is whether the US is in a recession. While it is commonly believed that a recession is a period of two or more consecutive quarters of negative economic (GDP) growth, that is not exactly how recessions are officially defined within the US. As of August 2022, the National Bureau of Economic Research (NBER) has not declared a recession in the US during any part of 2022.[1]
In an effort to better understand recessions, we explore how a recession is defined, what have been the recessions throughout US history, which indicators go in to determining a recession, how the US stock market has performed before and after a recession, and how an investor can prepare for recessions.
What Is A Recession?
The NBER's traditional definition of a recession is a significant decline in economic activity that is spread across the economy and that lasts more than a few months. The NBER believes that while each of the three criteria - depth, diffusion, and duration - needs to be met individually to some degree, extreme conditions revealed by one indicator may partially offset weaker indications from another.[2]
It is important to note that the start date for a recession is often declared in retrospect, meaning it is possible to be in a recession for a few months before it is officially declared.
Since 1928, there have been 15 recessions in the US lasting on average 12.5 months, according to the NBER.[1]
Source: “US Business Cycle Expansions and Contractions“. NBER, nber.org.
What Indicators Go In To Determining A Recession?
Data for all indicators can be found and downloaded from the Federal Reserve Bank of St. Louis FRED website. Indicators include:[2]
How Has The US Stock Market Performed Before A Recession?
Over the last 15 recessions, the S&P 500 has had an average annualized return of 15.80% during the two years before the start of a recession.[3] None of these two-year periods had a negative return. This is not a huge surprise, as the period before the start of a recession usually coincides with a peak in the business cycle.[1]
Sources: Dimensional Returns Web, NBER, Morningstar. Recession start dates are based on the US Business Cycle Expansions and Contractions data from the National Bureau of Economic Research. The S&P 500 total return index assumes reinvestment of all distributions. See Important Disclosure Information.
How Has The US Stock Market Performed After The Start Of A Recession?
Over the last 15 recessions, the S&P 500 has had an average annualized return of 5.97% during the two years following the start of recession.[3] While the average return is positive, the S&P 500 had a negative return in 5 of the 15 two-year periods. In some cases, the S&P 500 fell significantly (such as at the start of the Great Depression), fell but then rebounded quickly (such as during the start of the COVID-19 pandemic), or just didn’t really experience any outsized volatility (such as after World War II).[1]
Sources: Dimensional Returns Web, NBER, Morningstar. Recession start dates are based on the US Business Cycle Expansions and Contractions data from the National Bureau of Economic Research. The S&P 500 total return index assumes reinvestment of all distributions. See Important Disclosure Information.
Taking a longer-term view, the S&P 500 has eventually recovered and grown after all recessions over the past century, though in some recessions it has taken many years for this to happen.[3] The US stock market has been able to withstand the short-term volatility caused by recessions, growing significantly over time.
Sources: Dimensional Returns Web, NBER, Morningstar. Gray shaded areas represent periods of recession. Recession start and end dates are based on the US Business Cycle Expansions and Contractions data from the National Bureau of Economic Research. The S&P 500 total return index assumes reinvestment of all distributions. See Important Disclosure Information.
How Can You Prepare For A Recession?
Build Up Your Emergency Fund
An emergency fund can give you the ability and confidence to stick with your investment plan through a recession. The amount that you should save in your emergency fund partially depends on what would help you sleep comfortably at night if your investment portfolio begins to decline in value. Some people feel comfortable with an emergency fund with 6 months' worth of living expenses, while others prefer 1-2 years' worth of living expenses.
The idea behind an emergency fund as a way to make it through a recession is not new. Detailing his experiences living through the Great Depression, Benjamin Roth wrote in The Great Depression: A Diary, “This depression has indelibly impressed on my mind one thing - and that is the value of having on hand sufficient capital to cover emergencies. In the investment field it means the difference between success or failure to have enough capital to buy bargains when they are available or to hold on to investments thru thick and thin and not be forced to sell at a loss.“[4]
Diversify Across Stocks, Bonds, & Alternatives
Periods of negative US stock market performance are inevitable. By diversifying across global stocks, high-quality bonds, and alternative investments with low correlations to US stocks, you can help to limit the impact of a period of negative US stock market performance on your portfolio.
Review Your Asset Allocation Ahead Of Time
Your asset allocation refers to the amount of stocks, bonds, and alternatives that you hold in your investment portfolio. While it may be difficult to imagine how you may react to declines in your investment portfolio, we believe it is critical to choose a level of riskiness that you will be able to stick with during good investment times and bad.
Important Disclosure Information & Sources:
[1] “US Business Cycle Expansions and Contractions“. NBER, nber.org.
[2] “Business Cycle Dating Procedure: Frequently Asked Questions“. NBER, nber.org.
[3] The S&P 500 Index is a free float-adjusted market-capitalization-weighted index of 500 of the largest publicly traded companies in the United States.
[4] The Great Depression: A Diary. Benjamin Roth, 2010, Publicaffairs.
Indices are not available for direct investment. Index performance does not reflect the expenses associated with management of an actual portfolio. Index performance is measured in US dollars. The index performance figures assume the reinvestment of all income, including dividends and capital gains. The performance of the indices was obtained from published sources believed to be reliable but which are not warranted as to accuracy or completeness.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
Statements contained in this article that are not statements of historical fact are intended to be and are forward looking statements. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
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