In the past 100 years US stocks have nearly always begun to recover before recessions ended, but on no occasion did they hit bottom before a recession had begun.
The market mood has certainly been lifted by the lower-than-expected inflation reading last month. Investors are now betting on the Federal Reserve (Fed) to slow the pace of interest rate hikes.
But it seems premature for the equity markets to celebrate given the prospect of a recession in the world’s largest economy. The aggressive policy tightening by the Fed should eventually bite into economic activity and corporate profitability – even if aggregated bottom-up analyst forecasts currently suggest a market-wide decline in profits can be avoided.
Top-down analysis by our Schroders Economics Group expects the US to fall into recession (see Economic and Strategy Viewpoint - Q4 2022) in the first quarter of next year. The forecast is for real GDP to contract by 1.0% over the course of 2023 and for US corporate profits to decline by 14%. Meanwhile, the Schroders Recession Dashboard is on high alert (see Schroders Recession Dashboard: why we’re on high alert), indicating the blistering pace of US interest rate rises is taking effect. So, investors should brace for recession and a considerable drop in earnings.
It would be very unusual for the S&P 500 to bottom before the recession has even started (see Table 1, below ) which makes us fear that the recovery in markets since October could transpire to be another bear market rally.
The index has reached a low during nearly every recession officially dated by the NBER (National Bureau of Economic Research) since the 1920s. So, once a recession has begun, and despite everything possibly feeling very gloomy, investors do need to be prepared to look through it at some point.
There have only been two episodes when US equities only troughed after the recession had ended. These were relatively short-lived recessions triggered by the major events of World War II and the dotcom bubble bursting.
On average, the US stock market takes around five to eight months to find a floor during recessions and tends to bottom five months before the end of recessions. If the downturn is more severe and longer in duration, it has taken even longer for the S&P 500 to fall to a low. During the Covid-19 recession in 2020, the US stock market troughed less than a month after the start of the shortest recession in history. Back then, markets had looked through the collapse in economic activity from the self-imposed lockdowns and expected a sharp rebound in growth.
By contrast, the Great Depression was the longest US recession of the 20th century, and it took nearly three years before the S&P 500 reached its bottom. It was also the worst episode in terms of price performance as the market was over 80% down over the period. And, while the index has delivered negative returns on average during recessions, the picture is distorted by heavy losses suffered during the Great Depression and the Global Financial Crisis (GFC).
There have been periods when equity returns have been positive during recessions. Despite the contraction of economic activity and corporate earnings during downturns, the market can reprice based on the expectation of a recovery in the economy. Before we look at the re-rating of equities during recessions, let us talk about earnings.
One of the main drivers of the decline in the market during recessions is the collapse in corporate earnings. Historically, EPS (earnings per share) growth has been negative during most downturns as top-line growth of companies gets hit by the slump in economic activity (see Table 2, below). Despite a high chance of a recession next year, bottom-up analysts are still expecting positive earnings growth of 4.9% (Refinitiv, as at 02 December 2022). So, it would appear consensus expectations have yet to factor in potential earnings disappointments. Perhaps analysts anticipate companies will be able to protect profit margins by reducing costs such as cutting jobs.
While earnings are important, investors should not wait for the bottom in earnings to return to the market. Since the 1920s, the level of earnings has typically reached a floor after the recession has ended and eight to nine months after the S&P 500 has troughed. Earnings have lagged the market and have continued to fall until economic growth has troughed and is about to turn the corner. This is because there is a strong relationship between real GDP growth and earnings growth, as the well-being of the economy impacts top-line growth of companies (see Chart 1, below).
That said, there have been two recessions (which followed after World War II and the bursting of the dotcom bubble) when earnings troughed earlier than the S&P 500. In both episodes, investors did not go back to buying equities until there was confirmation of the bottoming in earnings.
By contrast, recessions where earnings took a longer time to reach the bottom compared to the S&P 500 tended to be periods when the Fed was late to the party in cutting interest rates (see Chart 2, above). In some instances, monetary policy was even tightened during the recession, so prolonging the negative impact on earnings. Perhaps this is relevant to the current business cycle.
According to the Schroders Economics Group, the Fed could still be hiking interest rates when the US is in recession and only start easing policy towards the end of it. This suggests that it could take some time for earnings to bottom compared to previous cycles.
On average, S&P 500 returns are negative during the first few months of a recession, particularly over the first six months (see chart 3, below). This is because investor sentiment towards the market gets hit by the significant deterioration in corporate earnings as the economy goes into recession.
But the market does not wait for bottom in earnings and equity performance rebounds strongly particularly towards the end of the recession. This re-rating in the market is driven by the combination of cheap equity valuations and expectations of a future recovery in the economy and corporate earnings.
Firstly, the de-rating in the market during recessions mean that US stocks become more attractive in terms of valuations. Looking at previous downturns, the trailing price-earnings ratio (P/E) and 12-month forward P/E ratio generally bottoms around 12x and 13x respectively (see chart 4, below). So, cheaper valuations draw investors back into the market.
But if history is a guide, there is still room for US equities to de-rate as P/E ratios are currently trading on higher multiples (12-month trailing at 21.3x and 12-month forward at 17.7x, Refinitiv, as at 02 December 2022) than typical levels seen during recessions.
Secondly, the re-rating in the market is strongly tied to the cutting of interest rates by the Fed during recessions (see chart 5, above). Investors anticipate the improvements in economic activity and corporate profitability from the easing in policy. Lower interest rates mean a fall in borrowing costs, which should help improve the future cash flow of companies and boost profit margins.
Typically, the US stock market reaches the bottom once the economy is in recession. This year, the market has largely de-rated on the pricing of higher interest rates. But arguably there is still room for corporate earnings forecasts to adjust. Analysts are still expecting positive earnings growth next year despite history telling us earnings are negative during recessions.
That said, investors should not wait for the bottom in earnings to return to the market. The S&P 500 tends to rebound strongly towards the end of recession. Besides more attractive valuations, the expectations of the recovery in the economy drives the re-rating in the market. Importantly, this is supported by the Fed easing policy. Given the sheer pace of policy tightening in this cycle, signs that the central bank is going to take a pause from further rate hikes could be enough to lift the market.
Overall, investors should not be complacent about downside risks to the equity market associated with a recession. The risk is made greater if inflation proves to be more persistent and the Fed does not ease policy as expected during the recession.