Downturns, Slumps, Contractions, Corrections, Bear Markets and Recessions

What Should You Know?

Recessions are minimally two declining quarters of Gross Domestic Product (GDP), but subject to the National Bureau of Economic Research (NBER) stating so. However, the causes are widespread. What’s common is some sort of triggering mechanism, some catalyst that leads to major investor sentiment falling rapidly, with contagion across assets accompanying the trigger. Thus, the correlation of assets “goes to 1” as the saying goes, meaning assets tighten their association and move together directionally — much like starling murmuration or schools of fish traveling in harmonious synchronization.

Big words with many syllables, but each investor, bird or fish is watching what their nearest neighbors are doing and mirroring it, basically. When the 7 closest stocks to the one you own start falling, your loss aversion threshold is breached and you “SELL.” When this emotion spreads wide enough, panic selling, or herd mentality, kicks in; selling pressure occurs, stock prices fall, and behold — a recession can begin. Not all recessions are triggered by falling markets, however, but almost all recessions trigger falling markets.

More Common Than You Think

Consider that market corrections and recessions are relatively frequent and normal when you look over, say, a century. The S&P 500 experiences a correction almost every year — within every 2 years for sure. There have been officially 23 recessions since 1900. Hence, we aren’t talking about something unusual, really. The important dynamic is that recoveries are even more fairly common and rapid, and often reach new time highs.

Can one predict a market crash or recession? Is the longer a bull market lasts a sign the next recession will be deeper and longer too? If stock valuations rise too high, is that a signal a recession or correction is about to happen? What can the investor do to protect themselves from a falling stock market? I don’t mean a few negative percent — I mean a significant drawdown.

What the Research says

Two good books review the major recessions and pullbacks over the last centuries and have some intriguing findings:

• Economic expansions and bull markets don’t die of old age — however, recessions do, with the frequency of death increasing the longer the recession lasts.
• The length of a recession doesn’t reflect the length or strength of the following bull market — they’re independent.
• Recessions are started by catalysts — shocks of some sort — and they’re not forecastable.
• Recessions don’t clear out deadwood. Though bankruptcies increase, they involve companies that would have gone bust anyway, and government rescues tend to exacerbate the situation and make the downturn last longer.
• After the recession, the growth trend resumes to the pace it had before the recession.

Commonalities of recessions include the catalyst, as already said, often accompanied by some new financial instrument where the marketplace doesn’t fully understand its risks. However, and firstly, the market is already set up precariously due to too much leverage, high valuations, geopolitics, macroeconomic factors, or high energy prices, and so forth. Usually, two or more of these factors exist simultaneously. So, in essence, the table setup is complete — it’s just awaiting the burnt dinner (catalyst) to be served.

Four Durable Ingredients

There are ingredients which have, however, proved durable over time.

Steven P. Greiner, Ph.D.

CIO & Founder, BlueFire Strategies LLC

Steven is Chief Investment Officer with over 30 years in asset management and equity research. He previously led the Schwab Equity Ratings team at Charles Schwab and holds a Ph.D. in Physical Chemistry from the University of Rochester.

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