Saturday, May 16, 2009

the pattern of recession

The economic events of 2008 were unusually severe, but they fit a historical pattern. Since 1945, the U.S. economy has experienced 12 recessions—about one every five and a half years1—and each recession has been followed by a period of expansion.

Painful as they may be, recessions help set the stage for the recoveries that follow. Economic contractions typically serve to correct issues that become problematic during periods of growth. For example, American companies took on huge amounts of debt during the 1990s as the U.S. economy enjoyed nearly a decade of strong growth. The economy slid into recession in 2001—and the Federal Reserve responded by cutting short-term interest rates to 40-year lows. Lower interest rates allowed companies to refinance debt, improve balance sheets, and position themselves for growth as the economy strengthened.

Similar forces are at work in the current recession. During the last economic expansion, burgeoning global growth led to enormous demand for energy and raw materials, causing prices to skyrocket. Oil prices, most notably, which had bottomed out at $10 a barrel in 1998, soared to $147 a barrel by early July 2008. Oil is an essential expense for most businesses, so higher prices squeezed profits for companies ranging from pizza delivery chains to airlines. But the current recession has acted as a pressure-release valve for oil and materials prices. Demand for oil has dropped, pushing prices down to $50 a barrel as of mid-March. While businesses face a host of challenges in this recession, high costs for energy and materials are not among them for the moment.

The current economic crisis also is forcing corporations to clean up their balance sheets, much as the 2001 recession did. Companies across the country are becoming more efficient and eliminating unprofitable lines of business. Those that can’t compete are being absorbed by competitors or simply going out of business—a Darwinian process known as “creative destruction” that eventually makes the economy more efficient.

Financial markets historically have responded to recessions in relatively consistent ways. Stocks typically have turned down before recessions, continued falling during recessions’ early stages, and rebounded strongly before the recessions ended.

When investors anticipate a recession, they tend to sell shares of economically sensitive companies while holding on to shares of firms that provide essentials such as food, electricity, household staples, and health care. This trend held true in the fourth quarter of 2008, when defensive sectors declined the least, as shown in the chart below. “When the going gets tough, people tend to eat, drink, smoke, and go to the doctor,” says Sam Stovall, chief investment strategist for Standard & Poor’s. “Industrials, technology, financials, and consumer discretionary shares generally take the biggest hit.”

Just as stocks usually start declining in advance of a recession, they typically rise well before the recession ends, as investors start anticipating a recovery. Indeed, in 10 of the last 11 complete recessions, the market rebounded before the recession’s end.6 (The exception: the bear market between 2000 and 2002, which had to work through extreme valuations and the bursting of the Internet bubble, in addition to economic weakness.) “The market trends up when things still feel really awful to a casual observer,” Hofschire says.

Recessionary rebounds tend to be dramatic. Stovall notes that the S&P 500 has gained 46%, on average, during the first 12 months of a bull market. As the economy turns around, investors typically gravitate back into economically sensitive equities, he says—in particular small cap stocks and cyclicals such as industrials, technology, financials, and consumer discretionary sectors. “Investors anticipate that things will improve, so they seek out the areas that are likely to improve the most,” says Stovall. Likewise, an improving economy typically draws investors away from bonds and toward the greater growth potential of equities.

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