The Investment Scientist

Archive for January 2008

What you need to know now the recession is here

Do you ever get that feeling that you’d rather just stay in bed? This morning was one of those mornings. We woke up to the painful news of stock market collapses across Asia and Europe. And then, more surprising, a sudden action by the Fed cutting the interest rate by three-quarters of a percentage point (75 basis points). We never know for sure whether we’re in a recession until National Bureau of Economic Research (NBER) makes it official. That could take up to six months. But the only conclusion I can draw from the immediacy of reaction from the Fed is that if we are not in a recession right now, it’s about to happen.

So what can we expect the stock market to do during a recession-and after it? I may not have a crystal ball to see the future, but I have made an in-depth study of all nine recessions since 1950. Even if history won’t repeat itself, looking at the past half-century should give us some perspective.

Things look gloomy now, but the future is not

How long does the average recession last?

Since 1950, a typical recession lasted for ten months. The shortest one lasted for six months and the longest one lasted for 16 months. (See column 2, Table 1 below.)

What have been typical returns during past nine recessions?

Five of the nine recessions saw the S&P 500 index increased during the downturn (See column 3, Table 1 below). The average index return during recessions was 3.14%.

One year into the start of a recession, the S&P 500 index, on average, increased an anemic 2.95%. (See column4, Table 1.) Yet there are only three instances during this period when the index dropped, and the largest of these was by a painful 27%. However, the remaining six first-year periods saw the index increase. The best of these was by 25%.

By the third year of the start of a recession, the S&P 500 index on average increased 28%, which is slightly below the normal rate of return for the index. There was only one instance when the index was below the start of the recession. (See column 5, Table 1.)

Ten years into the start of a recession, the S&P 500 index on average increased 139.6%. There were no instances of the index being below the start of such a long recession. It’s worth noting 139.6% for ten years is still below the normal rate of return for the S&P 500 index. (See column 6, Table1.)

Table 1: S&P 500 returns during and after recessions

Recessions # of months During R 1 year 3 year 10 year
Jul 1953 – May 1954 10 17.94% 25% 100% 179%
Aug 1957 – Apr1958 8 -3.94% 6% 26% 107%
Apri1960 – Feb 1961 10 16.68% 20% 28% 50%
Dec 1969 – Nov 1970 12 -5.28% 0% 28% 17%
Nov 1973 – Mar 1975 16 -13.13% -27% 6% 73%
Jan 1980 – Jul 1980 6 6.58% 13% 27% 188%
Jul 1981 – Nov 1982 16 5.81% -18% 15% 196%
Jul 1990 – Mar 1991 8 5.35% 9% 26% 302%
Mar 2001 – Nov 2001 8 -1.80% -1% -3%
Average 10 3.14% 2.95% 28.20% 139.16%
Current recession started Dec 2007 18 -34.8% -39.2% -9.9% ?

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Small cap value stocks will do better, if history repeats itself

I’ve used the Small-Cap Value Index constructed by Fama and French to study the effect of recession on small cap value stocks for the last nine recessions since 1950.

On average, the Small-Cap Value Index returned 11.39% during a recession. During those recssion periods, the returns of the Small-Cap Value Index ranged from barely dropping (-2.17% in the ’69 recession) to strongly rallying (38% in the ’81 recession). (See column 2, Table 2 below.)

One year into the start of a recession, the index on average returned 13.21% with only one instance of index decrease. (See column 3, Table 2.)

Three years into the start of a recession, the index on average returned 76.21%with 31% being the worst return. (See column 4, Table 2.)

Ten years into the start of a recession, the index on average returned 506.26% with 312% being the worst return and 1183% being the best. (See column 5, Table 2.)

The reason I recommend my long-term approach and staying with small cap value stocks is because of these results.

Table 2: Small cap value returns during and after recessions

Recessions
During R 1 year 3 year 10 year
Jul 1953 – May 1954 10.11% 21% 100% 362%
Aug 1957 – Apr 1958 -0.56% 18% 63% 517%
Apr 1960 – Feb1961 21.72% 32% 46% 343%
Dec1969 – Nov 1970 -2.17% 7% 31% 312%
Nov 1973 – Mar 1975 17.81% -13% 86% 1183%
Jan 1980 – Jul 1980 3.11% 15% 96% 499%
Jul 1981 – Nov1982 38.29% 0% 95% 387%
Jul 1990 – Mar 1991 5.52% 9% 83% 448%
Mar 2001 – Nov 2001 8.68% 31% 86%
Average
11.39% 13.21% 76.21% 506.26%

How shall we learn from history?

We can take the short view. In the last six months, the S&P 500 has dropped more than 15%. The Small-Cap Value Index has dropped more than 25%. Should we conclude that at this rate, all investment in stocks will be lost in two to three years?

Should you panic now?

The answer is no. But that’s precisely what many investors are doing now by taking money out of the market or rotating them to stocks they perceive to be safer. There is a better way to learn from history.

Take the long view

If you want to sleep well while building your wealth for the long term, you must take the long view of history. Then you’ll be more like Warren Buffet and John Bogle who see the current market madness as normal and transitory. William Shakespeare could well have been talking about the emotional turmoil of the market when he wrote,

It’s like a tale told by an idiot, full of sound and fury, but signifying nothing.

Sleep well, take the long view.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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