The Investment Scientist

Recession & Stocks: Shall We Be Afraid?

Posted on: November 30, 2007

What a difference one month made! When I left for vacation one month ago, the Sub-Prime Crisis appeared to be a spent force; when I returned, all talks are about recession. I am sure you have many questions (if you are like me): Will there be a recession? Will the stock market and the US economy survive a recession? What shall we do now? To answer those questions, I am burning late night oil now to review all past recessions after 1950 and how the stock market fared. History will not repeat itself exactly, but history is nevertheless a very useful guide.

stockmarketsandrecessions.gifPlease look at the first chart. The chart depicts the S&P 500 since 1950 in logarithmic scale. Periods of recession are yellow highlighted. Now what impression do you get? … My take is: if you investment horizon is 5 years and beyond, a recession is but a bump, you should just sit tight and ignore all the talks about recession. In fact, in all but one instance, the market returned to its pre-recession high within 3 years.

The Deepest Recession

The deepest post-war recession started in the last quarter of 1973 and lasted for 6 quarters. The recession was global in scale. It was triggered by the Arab-Israeli War and the subsequent Arab Oil Embargo. The S&P 500 dropped just over 40%. The current geopolitical and macro-economical landscapes are quite different. The global economy is very strong and the Arab and the Israeli are suing for peace.

The Most Similar Recession

The recession that has the most similar characteristic is the 1990 recession. It started in the second quarter of 1990 and lasted for 4 quarters. The recession was caused by a credit crisis from the Savings and Loan Debacle. The Savings and Loan Debacle is similar to the current Sub-Prime Crisis in that both are the result of imprudent lending and both cause a credit crisis. During this recession, The S&P 500 dropped just shy of 14% from peak to trough. It recovered very strong though. By the end of the recession, the market is higher than the beginning of the recession.

Will We Have a Recession?

Dr. Paul Samuelson famously said: “The stock market has accurately predicted 9 out of last 5 recessions.” Just because the market is very scared of a recession doesn’t mean one is coming. The world economy is very robust, and the drag caused by the contracting housing sector is more than made up by surging exports. The silver lining is consumer spendings, which account for 70% of the economy. The alarmists argue that the tumbling housing price and the surging oil price will kill off consumer spendings. The optimists argue that the job market is still very robust and pays are still increasing. The jury is still out.

Recession’s Impact on Different Sectors

If indeed the domestic consumption driven recession comes to pass, the most affected sector is likely to be Consumer Cyclical. The sectors that are most insulated are Technology and Capitals Goods. Both are driven by robust foreign markets and made more competitive by the falling dollar.

Be Cautious About Emerging Markets

Emerging Markets have done extremely well over the last few years. In the last two years alone, the Chinese market went up 400% and the Indian, the Brazilian and the Russian markets went up only slightly less. On November 5, Petro China was listed in the Shanghai Stock Exchange. It instantly became the largest company in capitalization in the world, doubling the capitalization of second place Exxon Mobile. (Petro China’s earning is about a quarter of Exxon Mobile’s.) As a matter of fact, 5 of the top 10 market cap stocks in the world are Chinese stocks. That’s pure magic! China is a land of opportunities for rough and tumble, hand on entrepreneurs with the right connections. For us armchair investors, we rely on an independent legal system, a solid accounting system and a fair disclosure system to safeguard our interests. I am afraid China and many emerging economies have none of the above yet.

What to do next?

If your investment horizon is more than 3 years, you should tune out the cacophony of market punditry. If your investment horizon is less than 3 years, some adjustments to your portfolio might be necessary. If your investment horizon is less than a year, you shouldn’t be in the market in the first place.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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