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Recessions…misunderstood?

May 28, 2019 by Miranda Carr

Over the last 70 years, the U.S. has experienced 11 recessions. Recessions have become less frequent since the Federal Reserve got ahold of inflation in the 1980s and learned to balance growth and employment with the associated inflation that comes with it through monetary policy. In fact, we have only seen three recessions since 1982, so that is about three recessions in the last 37 years and eight in the prior 33 years.

“What have you done for me lately?”  

Arguably, this limited exposure to recessions has caused us to fundamentally misunderstand recessions – or understand them only in the context of the large market drawdowns experienced in the early 2000s and in the Great Recession (2007-2009). Behavioral economists have identified a bias known as the “availability heuristic.” In short, this bias causes us to place more weight on things that are easier to recall and attach more significance to events that have happened more recently. The present application of this would be to assume that the next recession will be like the last. Even experienced and thoughtful professional economists are not very good at predicting the timing, duration, or depth of economic downturns or recoveries. If we look back at the set of recessions that occurred over the past 70 years, the associated market declines may surprise you.

Recessions 5.27.19

The Facts  (History)

A recession is traditionally defined as two consecutive quarters of negative GDP growth; although in the US, the National Bureau of Economic Research (NBER) has the final say if the economy is in recession or not. Often, the recession is announced several months after it actually began. For example, during the last recession, which technically began in December 2007, the NBER didn’t announce the economy had entered into a recession until a year later, in December 2008. The recession was closer to the end than the beginning by that point. The Great Recession was the longest and steepest downturn since World War II, with the economy contracting by 4.3% and the stock market declining by almost 60%. The recession that hit the U.S. in 2001 only saw a decline in GDP of 0.4%. The stock market, however, fell nearly 50%.

Not all recessions are this severe or cause the stock market to plunge by half. In fact, of the last 11 recessions, only four saw a related market sell-off over 27%. Keep in mind the stock market fell almost 20% in the fourth quarter of 2018, absent a recession. In about half of the recessions since World War II, the drawdown in the stock market was between 15% and 25%; and in all cases, investors would have been rewarded if they stayed invested – as the economy rebounded, the market rose to new highs each time. It’s impossible to time these things. Economists don’t even know we are in a recession until it’s nearly over, and often, stock markets hit their trough before the economy does.

How Recessions can hurt less

Recessions are painful – painful for workers who lose their jobs, painful for savers who see interest rates fall in response to falling growth, and painful for those who invest in risk-assets and see their investment account values slashed. But not all recessions wipe out ten years of return, and not all recessions persist for more than a year. Everyone is asking when we will experience the next recession. Of course, no one knows. There are signs that the economy is slowing, but it could continue to grow at a slow pace for years and keep asset prices rising as well. If you have a financial plan in place now, you will be prepared to weather whatever transpires over the near-term and long-term.

The economy rises and peaks then falls and troughs, and the cycle repeats. Be prepared for the next recession before it hits. It’s best to have an idea of what you will need to save for retirement and how you will invest it when markets are relatively stable. Financial planning assumptions build in the risk of recession, as they typically use historical rates of return including historical recessions and expansions. So make a plan, and stick to it, whether the market falls or exceeds expectations – and don’t panic. Remember the last seven decades of economic history and don’t fall prey to the availability bias by focusing on the last two decades.

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