What to Expect When This Stock Market Meets a Recession

Share on FacebookTweet about this on TwitterShare on LinkedInShare on Google+Share on RedditPrint this pageEmail this to someone

By Doug Short, Advisor Perspectives:

Last week I had a fascinating conversation with Neile Wolfe, of Wells Fargo Advisors, LLC., about high equity valuations and what happens when they collide with a recession.

Here is my monthly update that shows the average of the four valuation indicators: Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), Ed Easterling’s Crestmont P/E, James Tobin’s Q Ratio, and my own monthly regression analysis of the S&P 500:

Click to View

Based on the underlying data in the chart above, Neile made some cogent observations about the historical relationships between equity valuations, recessions and market prices:

  • High valuations lead to large stock market declines during recessions.
  • During secular bull markets, modest overvaluation does not produce large stock market declines.
  • During secular bear markets, modest overvaluation still produces large stock market declines.

Here is a table that highlights some of the key points. The rows are sorted by the valuation column.

Beginning with the market peak before the epic Crash of 1929, there have been fourteen recessions as defined by the National Bureau of Economic Research (NBER). The table above lists the recessions, the recession lengths, the valuation (as documented in the chart illustration above), the peak-to-trough changes in market price and GDP. The market price is based on the S&P Composite, an academic splicing of the S&P 500, which dates from 1957 and the S&P 90 for the earlier years (more on that splice here).

I’ve included a row for our current valuation, through the end of January, to assist us in making an assessment of potential risk of a near-term recession. The valuation that preceded the Tech Bubble tops the list and was associated with a 49.1% decline in the S&P 500. The largest decline, of course, was associated with the 43-month recession that began in 1929.

Note: Our current market valuation puts us between the two.

Here’s an interesting calculation not included in the table: Of the nine market declines associated with recessions that started with valuations above the mean, the average decline was -42.8%. Of the four declines that began with valuations below the mean, the average was -19.9% (and that doesn’t factor in the 1945 outlier recession associated with a market gain).

What are the Implications of Overvaluation for Portfolio Management?

Neile and I discussed his thoughts on the data in this table with respect to portfolio management. I came away with some key implications:

  • The S&P 500 is likely to decline severely during the next recession, and future index returns over the next 7 to 10 years are likely to be low.
  • Given this scenario, over the next 7 to 10 years a buy and hold strategy may not meet the return assumptions that many investors have for their portfolio.
  • Asset allocation in general and tactical asset allocation specifically are going to be THE important determinant of portfolio return during this time frame. Just buying and holding the S&P 500 is likely be disappointing.
  • Some market commentators argue that high long-term valuations (e.g., Shiller’s CAPE) no longer matter because accounting standards have changed and the stock market is still going up. However, the impact of elevated valuations — when it really matters — is expressed when the business cycle peaks and the next recession rolls around. Elevated valuations do not take a toll on portfolios so long as the economy is in expansion.

How Long Can Periods of Overvaluations Last?

Equity markets can stay at lofty valuation levels for a very long time. Consider the chart posted above. There are 1369 months in the series with only 58 months of valuations more than two Standard Deviations (STD) above the mean. They are:

  • September 1929 (i.e., only one month above 2 STDs prior to the Crash of 1929)
  • Fifty-one months during the Tech bubble (that’s over FOUR YEARS)
  • Six of the last seven months have been above 2 STDs

Stay tuned. Next week I’ll be updating the four valuation indicators I routinely track, and preliminary indications are that February will be another month of valution above 2 STDs. By Doug Short, Advisor Perspectives

It always starts with a toxic mix. Read…  “Perfect Storm” for Junk Bonds, Mutual Funds to Get Hit

Share on FacebookTweet about this on TwitterShare on LinkedInShare on Google+Share on RedditPrint this pageEmail this to someone

  8 comments for “What to Expect When This Stock Market Meets a Recession

  1. Vespa P200E
    Feb 25, 2015 at 8:13 pm

    Thanks for the Tobin’s Q ratio graph. Well, I think this time it might be different this time…

    I know it’s a cliche but we have very accommodating Feds kowtowing to the banksters with very loose monetary policy with ZIRP and rounds of QEs each round with less oomph. The very Feds who are afraid of the audit which makes one wonder what are they afraid of/trying to hide. ZIRP forced the investors and speculator alike into the ever riskier bond (and its web of derivatives) and equity market and the insanity may last longer than sane person expects until one of those black swan event unravels the market.

  2. Jungle Jim
    Feb 25, 2015 at 9:29 pm

    The point about over valuation is of course correct, but this time we have some complications. It has been several years since recorded corporate earnings would pass a smell test. Earnings have been heavily dependent on tax avoidance, cost cutting, and no apologies made padding (pardon moi “”positive discretionary accruals”).

    Worse, many companies have borrowed heavily to fund buy-backs and dividends. Call me silly or a cynic, but I wonder how much of that debt does not appear on balance sheets. Between stagnant earnings and gargantuan debt loads, this next recession is likely to be a doozy.

    Oh, and add me to the list of those who wonder why the Fed is so frightened of an audit.

  3. Julian the Apostate
    Feb 26, 2015 at 3:18 am

    “Quis custodiet ipsos custodes?” -Juvenal

    “In a city without watchdogs the fox is the overseer.”
    -Sumerian Proverb

  4. Dan Romig
    Feb 26, 2015 at 7:06 am

    Yes, the market is over priced by historical PE measures, but where does capital go?

    • Feb 26, 2015 at 7:39 am

      In a highly leveraged market in a highly leveraged (indebted) economy, when things turn the other way, “capital” (money) doesn’t go anywhere else. It just evaporates. Overall, money cannot be pulled out of the stock market. You can’t take your money and leave, you can only sell to someone else, hence new money must replace old money, and no money actually gets pulled out. However, when investors are eager to sell, and they reduce their margin debt and sell, markets head south, and capital just evaporates. POOOOF, gone.

  5. NOTaREALmerican
    Feb 26, 2015 at 12:12 pm

    Funny article. A recession! That made me laugh.

    The Fed has eliminated the business cycle (and pretty much all pricing).

    Buy now, or be prices out forever!

  6. ERG
    Feb 26, 2015 at 12:54 pm

    What happens when the stock market meets a recession?

    We already know the answer as we’ve been in an uninterrupted recession since 2009.

    It goes higher forever because the Fed will not let it do anything else.

    • michael
      Mar 1, 2015 at 1:20 pm

      Sorry the Fed cannot defy the laws of gravity indefinitely

Comments are closed.