The stock market has fallen 18.7% since its peak on January 3, 2022 (as written on May 21, 2022). Investors often define a bear market as a 20% drop from a high, so we’re close enough to feel the bear. Does the stock market decline herald a recession? It turns out that stock market declines are poor predictors of coming recessions. Understanding this helps our understanding of investments as well as economics.
Here’s a brief stock market summary for recessions since 1950, using a 20% drop in the Standard & Poor’s 500 index as an indicator of the coming recession (based on month-end values for easy calculations).
The stock market did not fall much from its previous peak around the recessions of 1953, 1957, 1960, 1980, 1981, or 1990. The stock market turned bearish at the same time the recessions of 1970 and 2020 began, therefore it did not provide any alerts. It provided a month’s notice for the 2001 recession. The stock market was three months late in its 1973 recession warning and eight months late in 2008. False warnings came in 1962, 1977 and 1987.
Obviously, this is not a great way for business leaders to anticipate global economic downturns. But perhaps the 20% drop from the previous peak is too strict a criterion. We could try 10% cuts. Here is what this threshold shows.
No advance warning came for the 1980 recession. The recessions of 1952, 1981 and 1990, 2008 and 2020 had simultaneous signals, so no advance warning. The advance warning came one month before the 1960 recession, five months before the 2001 recession, six months before the 1970 recession and seven months before the 1957 and 1973 recessions, the false alarms occurred in 1962 and 1962 , 1971, 1984, 1987, 1998, 2018.
Although not a great record, a sharp decline in the stock market deserves special attention.
Why would the stock market fall if not for an upcoming recession? A good start to analysis is dividend discount model, in which the value of a stock is equal to the expected future dividends discounted to the time value of money. The present value of a share, denoted V0is given by:
where D denotes the expected dividend for a given year and r denotes the interest rate. Divisors, (1+r) raised to a power, reduce dividends to reflect the time value of money.
What could lower the value of a stock? Suppose most investors expect dividends to grow by 10% per year. Then they revised their thinking to just 8% annual growth. It’s still consistent with an expanding economy, but it’s not as strong as the previous hypothesis. The value of the shares would fall. Another cause of a stock market decline could be a rise in interest rates, although this does not affect future dividends. With higher interest rates, money in the future will be worth less than it was before, so stock prices would fall. This is in addition to a possible drop in dividends that rising interest rates could trigger.
In addition to the dividend discount model, many other analytical approaches can be used to estimate the value of stocks, but with the same conclusion: there are plausible reasons for stocks to fall that do not imply a recession.
Let’s not forget the emotions. People will sometimes be frightened by political events, business headlines or other news. Thus, a decline in stock markets does not necessarily tell us what is happening in the world of spending, production and employment. The stock market may be worth watching, but its signals are pretty fallible
Does this review of the data prove that the economy is not in recession? No, a recession is certainly possible. Interest rates are rising, energy costs are rising, and some consumers can’t keep up with their recent spending as inflation outpaces wage growth. However, the economy continues to feel the benefits of past stimulus measures, both government spending and accommodative monetary policy. The stimulus is felt in the economy over time, and we are still enjoying the benefits of last year’s money creation.
The change in monetary policy will be felt mainly in 2023, and even then it will be a gradual change. Recession is much more likely in 2024 than this year or next, but even then it’s not a certainty. The Federal Reserve can back out of its inflation-fighting stance when employment weakens. The lag between the effects of monetary policy on employment is about half as long as the lag in the slowdown of inflation. So next summer the Fed will see its tightening slow job growth but do little to limit inflation. It is noon, when we learn the character of the decision-makers of the Fed. The most likely course is for the Fed to continue to fight inflation, but if it falters, then no recession in 2024. But if it falters, expect a downturn when a late-day Paul Volcker is finally dispatched to do the job.