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Investors fear few things quite as much as recessions. Economic declines normally weigh on corporate earnings, and that can directly impact equity prices. Although major market declines have at times occurred without recessions, the economy is clearly a primary risk for investors.

Understanding the Economic Data

The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), which decides when recessions begin and end, defines recession as a “significant decline in economic activity spread across the economy, lasting more than a few months.” That has often been interpreted as at least two successive quarters of economic decline, but officially declared recessions have not always met that criterion. Since 1854, there have been 33 declared recessions. The average time from start to finish was almost 18 months. The shortest ran six to eight months, while the longest on record, 1873 to 1879, lasted over five years.

The process of identifying recessions is more complicated than most people realize. Economic data is often subject to major revisions. For that reason, it takes the NBER six to 12 months to declare economic turning points. That means we are usually well into a recession, or out of one, before the NBER makes its official call.

Even with the benefit of hindsight, moreover, the data are not always clear. Inflation-adjusted (real) gross domestic product (GDP) comes closest to defining overall economic growth, but the government only publishes GDP data quarterly and the measurement errors that occur can be significant. Because the NBER believes that recessions are also visible in “real income, employment, industrial production and wholesale-retail sales,” they monitor a broad range of economic data to help identify economic peaks and troughs more accurately.

The Impact of Recession

It is important to note that economic shocks do not become recessions unless they have broad economic impact. Contractions in narrow parts of the economy, even if they involve critical inputs like energy or credit availability, do not become recessions until the shock spreads. When businesses suffer reduced sales and falling profits, they reduce employment and investment. When consumers suffer layoffs or reduced income, they compensate by cutting back on spending. Economists note that the shock of higher interest rates, which slow the economy by making credit more expensive and less available, usually take the better part of a year to fully work through the economy. As shocks spread, the leading economic indicators progressively deteriorate over the months leading to a recession.

Recessions also reduce corporate profits – and force weak businesses to close. That forges a strong relationship between economic conditions and major market declines. Since the early 1980s, when leading economic indicators have remained positive there was only a 5% chance of an equity decline of 20% or more over the next 12 months. But when leading economic indicators deteriorated significantly, the odds of a 20% or greater decline over the next 12 months rose to 90%.

Economic conditions can also help to predict the severity of market declines. We analyzed the economy’s role in market declines using Ned Davis Research’s classification of bear markets since 1900. Roughly 80% of the bear markets identified occurred in association with periods of economic upheaval. Particularly when recessions occurred during long-term economic crises, equity declines were much more severe. Bear markets that occurred when there was no major economic slowing declined only about half as much (22%) and lasted a much shorter time (five months) than the bear markets associated with recessions during periods of long-term economic crisis (42% over 18 months). Although bear markets can clearly occur while the economy is still growing, they are clearly much less severe when there is no significant economic slowing.

And economic factors sometimes play a critical role even if no recession occurs. Overly restrictive Federal Reserve policy frequently causes recessions. At times, however, as in 1987, market reactions to economic fears prompted the Fed to ease policy before a recession had time to develop. That seems to be playing out again, as the sharp market decline last year helped convince the Fed to “patiently” give the economy more time before they implement additional rate hikes.

Current Outlook

Economic growth is clearly slowing, so fears of recession may again send equity prices lower in the coming months. Leading economic indicators can help us judge whether market weakness is more likely to be a deep and long decline or to reverse quickly.

Most indicators currently suggest minimal odds of recession, and the economy does not show the longer-term excesses that have normally lead to crises. While that does not guarantee we will avoid a major market decline, it significantly improves the odds. We currently see a positive outlook for equities over the next 12 months but also caution that it will be important to closely monitor the leading indicators as economic growth continues to slow.

About Bruce McCain, Ph.D., CFA®

Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.

Disclosures

Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

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