Jun 30, 2022

The R Word and Equity Returns

With high inflation, the Fed increasing rates to cool inflation, the Russian invasion of Ukraine with its impact on energy prices and agricultural prices, there is the obvious risk of a recession in the U.S. On average, recessions tend not to be kind to the equity markets. During all U.S.recessions since 1873 and using the Schiller S&P price index series, equity price returns have averaged -8.4% with the range being -79.3% (the Great Depression) to 31.0% (recession of 1926-1927).  However, coming out of a recession, returns tend to do better. Measured six months after the end of a recession, U.S. equity price returns have average 15.2% with the range being -4.5% to 69.8%.  Six months after the end of a recession, equity returns have been positive for the investor in 28 of the 30 recessions since 1873 - hence, 93% of the time.  

Of course, in general, one does not know the exact dates a recession starts or ends until after it is over. However, through most of it, one is aware that a recession is happening. For the purpose of this analysis, the exact dates of recessions are from the National Bureau of Economic Research (NBER), which is an American research organization known for providing start and end dates for recessions in the United States. From the NBER website, “the NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is 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”.   

The question is when to start to be optimistic about the U.S. equity market during a recession. For that, we have looked to the 3-month change in ISM’s Manufacturing Purchasing Managers Index (PMI). We have data on the PMI starting in December 1978, Most of the time the PMI 3-month change is a small number (both positive and negative). During a recession, the 3-month change can become a large negative percentage, but when the economy is coming out of a recession, the 3-month change can become a large positive percentage. For starting the measurement of the performance of the U.S. equity market coming out of a recession, the signal we use is the first month in which the 3-month change in the PMI turns positive 10%1 or more. This positive change can happen during a recession or shortly after it ends. (although we do not know the NBER official date of the end until sometimes months later).  Once we have the PMI signal, we measure the performance of the U.S. equity market over the next 6 months. The performance of the market is shown in the figure below. 

S&P Price Returns 6 Months After PMI Change > 10%
Recession Dates on X-axis

As can be seen from the chart, during each of the recession since 1978,  six months after the 3 month change in the PMI has changed by 10% or more, returns to the U.S. equity market have been positive and have averaged 11.5%

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