Is Recession 'Priced In' To Stocks?

"It's easy to see, hard to foresee." ~ Benjamin Franklin

The stock market is often referred to as a "discount mechanism."  Discounting, in reference to stocks, is essentially a means of pricing the value of stocks today based upon their expected value in the future, typically six to nine months in time -- a "crystal ball," if you will, reflecting forward expectations of economic health.

In other words, much like a barometer that measures the general business and consumer confidence of our economy, stock prices today reflect our nation's general economic health six months from now.  For this reason, the stock market, as measured by the S&P 500, is a component of the economic Index of Leading Indicators.  Common sense would follow that all of the informed analysts and investors' scrutinization of quarterly corporate financial reports and macro-economic data would place their collective finger on the pulse of the economy... and yet a reliably consistent "forecast" still falls short...

Could the stock market and its participants see a recession in its crystal ball now?  Using a bit of logic and history, it is beginning to look that way... whether its forecast is correct or not... 

From the high mark on October 11, 2007, to the recent low mark put in on January 23, 2008, the price movement of the S&P 500 is a 19.4% decline.  Of course, we will not attempt to "call a bottom" or make any predictions here, but let's make a few observations with data taken from Fidelity's Market Analysis, Research & Education (MARE) titled, Has the U.S. Stock Market Discounted a Recession?:

Economic recessions generally coincide with stock market downturns; the last four recessions coincided with market conditions of between 17% and 49%.

Because economic data lags & stock markets look forward, sometimes much of stock market declines have occurred before a recession is officially diagnosed.

The circumstances surrounding [the 1990] recession might be the most similar to today: a real-estate-induced economic downturn; a banking system spillover; the Federal Reserve already easing; and average stock valuations.

OK, let's absorb this information and make some sense of it:  If economic recessions are typically "diagnosed" six months after they begin and stock prices lead recession by six months, then we may have already entered a recession that may not be officially diagnosed for several months.  Let's consider a "key takeaway" and a bit of paraphrased data highlighted in the MARE article:

The important thing is not whether the U.S. economy has or may enter recession, but to what extent the stock market may have already discounted economic weakness.

For the recession starting August 1990, the total stock market decline (peak to trough) was -20%. 

Fed Action prior to recession was "easing..."  Stock valuation prior to recession start was "average..." Stock market performance 12 months after recession trough/announcement was 27%...

A few more thoughts: 

• If economic recession has begun, it may not be "officially diagnosed" until the third quarter, at which time stock prices may discount or "forecast" a recovery in 2009. 
• Since economists look back and investors look forward, an announcement of recession, if and when it comes, is a signal to prudent investors that a recovery for stocks is just around the corrner.
• At the same time, sound investment strategies and, of course, timeless wisdom, tell us that we would be foolish to assume the "worst is over" now.  In fact, the prudent investor prepared for this market downturn months ago and long-term investment decisions are not led by short-term market conditions...
• Time in the market is more likely to prevail over timing the market, and prudent investing really is about diversification, asset allocation, simplicity, moderation, and, of course, self-awareness...

While there is no way of knowing how far stock prices will fall before resuming a sustained march forward, the oft-repeated wisdom of Mark Twain, "history does not repeat itself, but it does rhyme," should be the mantra of prudent investing: Logic would follow that a 20% decline, which has already been marked as of January 22, 2008, suggests, at a minimum, that the beginning of the end of the decline may be upon us -- once again, based on the "rhyme of history."

Stay tuned...

Related Post: Understanding Cycles Part 2: Stocks & The Economy

TFPAuthor, Kent N. Thune, QPFC, is the President and founder of Atlantic Capital Investments, LLC (ACI), a 'fee-only' Registered Investment Advisory firm located in Mount Pleasant, SC.

Comments

[Greg Feirman]

Kent,

I addressed this same topic on Friday. I think stocks are priced for a "mild" recession:

http://www.topgunfp.com/stocks-now-priced-for-mild-recession/

[Kirk]

The problem with looking at a previous recession, in this case 1990, and claiming history rhymes is you may be looking at the wrong period. What if we are in a 73 and 74 period. Rates below inflation, high oil, nasty international and costly war.

Or, could you make an argument for 1933? A few years past a stock market bubble, deflation in housing, enormous debt by the government, corporations and individuals.

[The Financial Philosopher]

Kirk:

You are absolutely correct, especially if you are saying that investment decisions should not be made based on history alone...

To answer the question my post is asking, "Is Recession Priced Into Stocks?:" The answer, based on the "rhyme" of history, would be "probably." Should we invest our assets expecting a "repeat" of 1990 or any other period? Absolutely not...

Thanks for your thoughts...

[Hamed Elbarki]

Great information... if only we had that crystal ball!