Business Cycles and Markets

I've been asked several times about the recent ECRI recession call (obviously I disagreed with their incorrect recession call in 2011 - I wasn't even on recession watch then and I'm not on recession watch now - and I also think ECRI is wrong about a recession starting in mid-2012). Several people have written about ECRI's call, see Menzie Chinn at Econbrowser, NDD at the Bonddad blog, and Henry Blodget at Business Insider.

It seems to me ECRI is trying to make this an academic exercise and hoping for some significant downward revisions. Right now the data doesn't indicate a recession in 2012, but, as Menzie Chinn notes, "all of these series will be revised, so one wouldn't want to state definitively we are not in a recession ' therein lies the path to embarrassment. But the case still has to be made for recession."

But why do we care? Here is a repeat of a post I wrote in early 2011 (with updated tables and charts):

From 2011 [updates in brackets]: Here is something very different. This is NOT intended as investment advice.

Why is there so much focus on the business cycle? For companies, especially cyclical companies, the reason is obvious ' it helps with planning, staffing and investment. [Update: Most cyclical companies are expanding now]

But why are investors so focused on the business cycle? Obviously earnings decline in a recession, and stock prices fall too. The following graph shows the year-over-year (YoY) change in the S&P 500 (using average monthly prices) since 1970. Notice that the market usually declines YoY in a recession.

Note: Because this is 'year-over-year' there is a lag to the S&P 500 data. [Graph updated to March 2013]

Click on graph for larger image.

So calling a recession isn't just an academic exercise, there is some opportunity to preserve capital.

Not all downturns in the stock market are associated with recessions. As an example, the 1987 market crash was during an economic expansion. And the stock bubble collapse lasted from March 2000 through early 2003 ' and the only official economic recession during that period was 7 months in 2001.

Although I don't give investment advice, I think investors should measure their performance with some index. Warren Buffett likes to use the S&P 500 index, so I also used the S&P 500 for this exercise.

Imagine if we could call recessions in real time, and if we could predict recoveries in advance. The following table shows the performance of a buy-and-hold strategy (with dividend reinvestment), compared to a strategy of market timing based on 1) selling when a recession starts, and 2) buying 6 months before a recession ends.

For the buy and sell prices, I averaged the S&P 500 closing price for the entire month (no cherry picking price ' just cherry picking the timing with 20/20 hindsight).

I assumed an investor started at four different times, in January of 1970, 1980, 1990, and 2000 [UPDATE: added 2010 start].