Recessions and Bear Markets: Understanding The Relationship By Gabe Hoffmann, SmithBarney Recent economic and capital markets developments have contributed to a surge in stock-market volatility, leading some investors to worry that the odds of a recession have risen—along with the risk of a significant market downturn. Many investors are nervous because they assume an economic recession would lead to a decline in corporate profits, which would likely push stock prices down. This may sound like a plausible assumption, however, it also could be wrong. The historical record suggests the link between recessions and bear markets is not a tight one. Over the past 11 recessions (as defined by the National Bureau of Economic Research, a nonprofit research group) the Standard & Poor’s 500 Index posted an average annualized return of 12.1%—a percentage point and a half higher than the index’s 81-year annualized return. All told, market returns have been positive in seven of the past 11 recessions. Such results may seem illogical at first glance, given that recessions usually are bad for corporate profits—and sometimes very bad. Commerce Department figures show that corporate earnings have fallen in all but two of the 10 recessions since World War II—with an average annualized decline of almost 10%. Standard financial theory teaches that the price of a stock should reflect the stream of earnings it is expected to produce. So, all else being equal, lower earnings should mean lower equity valuations and negative returns. But all things are seldom equal. Further analysis reveals that other factors frequently influence stock prices, even during recessions. These forces can include: • Inflation. Rapid price increases may create uncertainty about the quality of corporate earnings—and the real value of future earnings. This uncertainty can push down stock prices. Conversely, if an economic slump slows inflation, stock prices might rise, or at least not fall as much as they would have fallen otherwise. • Interest rates. The Fed typically reacts to a recession by quickly lowering short-term interest rates. Long-term bond yields often also decline. Lower rates increase the relative attractiveness of equities, which can help offset lower earnings. • Noneconomic shocks. Unexpected bad news, such as a war or terrorist attack, can drive stock prices down, worsening the impact of a recession. Good news like tax cuts, peace deals or mergers, can drive prices higher, despite a recession. • Investor psychology. Sometimes markets rise and fall for reasons that seem to have little or nothing to do with economic fundamentals. The 1987 bear market, for example, occurred at a time when economic growth was accelerating. It’s also important to understand that financial markets tend to be forward looking. That is to say, prices are usually influenced by what investors expect to happen, not what has already happened. Periods before a recession often see a spike in market volatility, as investors react to rising uncertainty about the direction of earnings. In seven of the last 10 recessions, profits also peaked before the economy did, giving investors additional reason to be cautious. By the same token, however, the market often hits bottom and starts to recover before the economy does—as investors begin to anticipate a rebound in earnings. Past performance is no guarantee of future results, but history suggests that recessions, like bear markets, are short-term corrections in a longer-term rising trend. Investors who have tried to second-guess the market—for example, by exiting the stock market when they thought a recession was at hand and jumping back into the market when they thought the economy had hit bottom—often have been disappointed. For most investors, the wisest course is to develop a long-term investment strategy and stick to it, even during market corrections and economic downturns. Gabe Hoffmann is Senior Vice-President of Wealth Management for the financial firm Citi SmithBarney. He is a resident of the Arboleda community in northeast Mesa, where he lives with his wife Mazie and three children; Garrett, Tyler and Lexie. Mr. Hoffmann ca be reached at (480) 345-4731. Citigroup Inc., its affiliates and its employees are not in the business of providing tax or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. 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