Stock Drops Don't Always Accurately Indicate Recession

ByK.C. Swanson

April 3, 2001 -- Amid all the weeping and gnashing of teeth over the market's decline,

here's something that might make you feel better: While it may seem like a market decline this nasty would be a sure indicator of recession, history suggests things could go either way.

In fact, it turns out that in almost half of all cases, sustained dropsin stock prices don't go hand-in-hand with a recession.

"You can have the market decline and not have the economy fall apart," says Randall Kroszner, an economics professor at the University of Chicago business school. "There's no necessary connection, though they can be connected."

According to data from the Investment Company Institute, a mutual fundtrade group, there have been half a dozen times in the last 60 years when the stock market has dropped steeply but the economy has managed to avoid veering into recession. (ICI researchers considered a decline to be at least 20 percent over three or four months, or of at least 9 percent over five months or more).

To put a precise number on an oft-misquoted phrase: Of the 14 majorstock market cycles since 1942, six were not associated withrecessions.

"The stock market predicted 14 recessions, and only eight haveactually come true," says Jim Bianco, president of Bianco Research.

Avoiding Recession

But how could there be a sustained, sizable market drop without arecession? It would seem like a bear market would forecast trouble brewing in the broader economy.

But that's not always the case. The market looks far into the future, points out Kroszner, "so a change in the way people view the 10- or 20-year growth rate can have an important effect on overall stock market valuations, but GDP growth may not be affected in the short-term."

A downturn limited to the stock market might also happen ifanalysts were to change their ideas about whether certain kinds ofcompanies are profiting from trends, he suggests.

Either way, when skepticism remains limited to a few areas of themarket, recession can often be avoided. That's the conclusion that can be drawn from a survey of post-War financial history: In cases where market declines occurred without recessions, the market downturns tended to be narrowly focused.

A shining example is the market crash of '87. "I think that's the mostprominent case of the economy that didn't bark," says Kroszner.

"The very large stock market decline in October generated a great deal of uncertainty and consternation and garment-rending, but had no effect on the economy. It was such a sharp change in such a small period of time that people were concerned that it would undermine confidence. Economic growth was a little bit lower that quarter, but things moved right back, and as far as I can tell, there was no long-term consequence."

Broad Vs. Limited Declines

Or consider a couple of other isolated market drops: the '61-'62decline, says Bianco, happened after President Kennedy said he wouldnationalize the steel industry, and related stocks got pummeled.

The downturn in '83-'84 was the aftermath of a tech bubble, when lots of PC outfits came public (sound familiar?).

What those examples have in common is that none of the market declineswere broadly based. Bianco thinks we may be able to steer clear ofrecession now for that same reason.

"The decline today is almost solely in communications and tech," he says. "If you look at stocks away from communications and tech, they're holding up reasonably well. Most of the industry groups — cyclicals, transportation, utilities, financials — are higher now than they were a year ago."

The caveat, he adds, is if those non-tech stocks were to run into problems too, in that case, a broader downturn could forecast recession.

To be sure, another problem that sets the current situation apart fromprevious examples is that the tech stocks contributing to the narrowdecline also happen to be widely owned.

That wasn't the case, at least to the same extent, before. There's been plenty of debate over how Nasdaq-focused losses could impact the economy via the wealth effect.

Looking Beyond Techs

But setting aside the Nasdaq, it turns out the current downturn in thebroader market isn't as nasty as some of its predecessors. In fact, theextent of the S&P 500's decline is pretty much par for the course.

Through last Thursday the index was 20.1 percent below the August monthly average of 1485.5, with an average of 1187.1 for the month to date. That's almost exactly typical of a downturn. According to ICI researchers, the average decrease in the index for all the contractions studied was 19.5 percent.

As hideous as things may be, they've been worse before. The S&P'sbiggest drop took place in the downturn of 1973-74, when the monthlyaverage of the market plunged 43.4 percent.

And so far, the current decline has been relatively short in duration.It's lasted eight months, dating from the S&P 500's peak (measured by the monthly average) in August 2000.

In the past, the duration of market contractions has ranged from as little as four months to as long as 37 months, with the average downturn lasting 14 months.

Although there's no way of knowing how much longer the current downturnwill continue, it's still relatively young. That matters because longercontractions tend to be more closely associated with recessions.

In five of the six times that market downturns didn't indicaterecessions, the declines lasted less than a year.

Viewed in a historical perspective, the relative brevity and especiallythe focused nature of the current market downturn may be reasons foroptimism.

For investors who can look beyond tech, Bianco says, "This is the greatest stockpicker's market ever. The fact of the matter is, 75 percent of the stock market is not technology. There are a lot of those stocks out there, but no one wants to play. They all want to try to catch a bounce in Cisco."