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The Stock Market has Predicted 9 of the Past 5 Recessions

by in Trusted Advice

The quote in the title is attributed to the first American winner of the Nobel prize in economics Paul Samuelson.  It highlights both the volatility of the markets and their forecasting ability.  This is not to say forecasting is easy, just ask any weatherman, just to point out that the market doesn't always get it right.  With the S&P 500 down approximately 11% from it recent high in November, we thought it would be a good time to review the history of these pullbacks and put them in perspective.

As we mentioned in prior posts, corrections of over 10% in the stock market happen on average every 18 months or so, depending upon the time frame used in the study.  Before the over 10% drop this past August and September, we hadn't had one since the Spring of 2012.  Before that in 2011, we had both a 19% and almost 10% correction and 2010 had a 16% correction.  All of these occurred during an almost 7 year bull market from the lows in March of 2009.  In the meantime, the US economy has continued to grow since the recession ended in June of 2009 and the S&P 500 has put in positive performance in 5 of the 7 years, with the other two being basically flat.

GTM JPAM interyear stock market declines January 31 16

In fact, according to Ned Davis Research, since the end of 1945, or 70 years, we have had 75 declines in the stock market of between 5 and 10% and 26 declines between 10 and 20%. The average time for the market to recover from these declines were 1 month for the 5-10% drops and 3 months for the 10-20% declines.  Even for the 8 times the market dropped between 20 and 40%, it recovered on average in only 14 months.

So an investor needs to ask themselves two questions.  The first is: What is my time horizon?  If you need the money within 14 months to two years, and can't wait for the market to recover, then those funds probably shouldn't be in stocks.  At that point you may want to rethink either your risk tolerance or your asset allocation or both. The next question then, is where are we in the market and economic cycles?  Is this one of the four false predictions, or five accurate ones so to speak?

As mentioned in our latest quarterly newlsetter, on the negative side of the ledger are: fears of slowing/collapsing Chinese growth, concerns over the Fed's plans to raise short term interest rates, a manufacturing recession, deflationary pressures, and increasing geopolitical risks.  On the plus side, you have solid employment growth, declining unemployment (see charts below from the February 5, 2016 Bureau of Labor Statistics Employment Report), wages starting to pick up, and still growing service Purchasing Managers Index (PMI). 

BLS Jobs report Feb52016 charts

With two thirds of the economy service based and growing, jobs still being generated at a rate above that needed to absorb new entrants, low gasoline prices serving as a tax cut, these and other factors lead to a  Leading Economic Indicator (LEI) Index still in an uptrend.  Recessions tend to be preceded by negative year over year readings in the LEI, usually with around a twelve month lead time. 

Conference Board LEI Jan2016

So at the moment, it would appear we are not going into a recession.  In the meantime, the market is grappling with a large amount of uncertainty.  Due to that uncertainty generating natural human fear, investors are taking every chance to drive down stocks at the merest hint of bad news, for that company, industry or even the market.  While it can be painful, this type of situation can give us at Covenant an opportunity many other advisors don't have.  Many advisors have shifted to using ETF's, either themselves or outsourcing it to others.  Thus indiscriminate selling of industry ETF's drives down the prices of excellent companies far below where they should be as they are part of the same industry as bad companies.  If a company in an industry announces bad news, the entire sector gets taken out, even if some of that bad news may be because the other companies are taking share from the announcer.  With our disciplined approach, we at Covenant, can then invest in the beaten down stocks of excellent companies and better position your portfolios for the eventual rebound, while ETF based managers are left holding a mixed bag of both the good and the bad.  





Blog posted from Chester, NJ 07930, USA View larger map


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