Today’s Insight is a five-minute read. You can scroll right to the bottom to get the summary, but we may be stating the obvious. We encourage you to scroll through the full article before reading the summary, because some of the data is actually quite interesting!
The level of recession risk here in the United States remains rather muted today, but the global slowdown is starting to bleed into a number of US economic data points. The conversation may begin to shift from a potential slowdown in growth to the probability of a hard or soft landing.
At Tamco, we do not attempt to predict what will happen in the future. We see this as a fool’s errand. Monitoring the state of the economy however, should be relevant to anyone who owns financial assets.
Understanding the potential downside of investing through a recession is an important part of risk management.
The common definition of a recession is two consecutive quarters of negative GDP growth, but the National Bureau of Economic Research defines recession as: “A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
Going through 90 years of data, we looked back at 14 recessionary periods here in America to determine the historical risk of investing in the stock market throughout past recessions.
We also looked at a couple additional factors to see if there were any relevant observations we could observe from the data.
To look at the impact of investing through a recession, we modeled the historical 1-year, 3-year and 5-year returns assuming that the initial investment was made at the start of each recession. We also looked at the Duration of each recession along with the Price to Earnings Ratio and the Risk-Free Rate at the beginning of each recession.
Source: NYU Stern, Telos Asset Management Company, Federal Reserve Bank of St. Louis, Macrotrends.com, Capital IQ
Being careful to not make any sweeping conclusions based on 14 data points, we do think a few observations are worth noting:
We assessed risk appetite by looking at the Risk-Free Rate and the Price to Earnings Ratio that investors were willing to accept when they unknowingly put their capital to work at the start of past recessions.
These two pieces of data theoretically work together by the fact that investors should demand a higher rate of return from risky assets when risk-free yields are higher (ie. investing in the S&P 500 at 20 times earnings would not be very attractive if the 10-Year Treasury bond was paying a 12% yield). This sounds great in theory, but it often breaks down in the real world.
The reason we looked at the Risk-Free Rate separately from the Price to Earnings Ratio was to see if there was any evidence that higher rates equip the Fed to assist in a softer landing.
We saw very little evidence that the risk-free rate at the beginning of the recession had any impact on short-term outcomes.
Source: Telos Asset Management Company, Macrotrends.com, Federal Reserve Bank of St. Louis, Capital IQ
In 75% of the recessions that started with equities trading at high valuations (above 15 times earnings), the first-year returns were negative and the average of all 1-Year returns for the “expensive” cohort was -16%. However, when stocks were trading at less expensive levels (less than 15 times earnings), four out of six recessions had positive 1-Year returns with an average return of +15%.
Source: Telos Asset Management Company, Federal Reserve Bank of St. Louis, Capital IQ