Timing investments around recession is tough
The economic climate is starting to look like a recession and feel like a recession.
But that doesn't necessarily mean a recession has arrived, which may cause problems for anyone trying to time their investment moves around the economic cycle.
Recession talk has heightened in recent weeks with telltale signs of weakness - everything from the housing slump and avalanche of banking writedowns to recent revelations of slowing export orders and evaporating job growth.
And, certainly, lots of people are feeling the pinch. But this still doesn't mean we're in a recession.
More to the point, nobody will know for sure for several more months.
The popular definition of a recession is two consecutive quarters of a contracting economy, signified by declining real gross domestic product.
But the National Bureau of Economic Research, a private group and arbiter of economic cycles, provides a slightly different definition - a "significant decline in activity" that tracks various indicators.
Recession pronouncements and economic turning points typically aren't determined until well after the fact.
The last cyclical bottom for the economy, in November 2001, wasn't acknowledged by the bureau until July 2003. That recession lasted eight months but took a lot longer to call, partly because the resulting recovery started out in such low gear.
The timing issue creates a dilemma for investors seeking to switch their portfolios out of the stock market to avoid economic downturns and get back in for the recovery.
Not only are GDP data released and revised months after the fact but, in contrast, investors tend to be forward-looking, meaning prices reflect expectations for business conditions several months hence.
The timing inconsistency has given rise to false alarms along the way.
"The financial markets have (incorrectly) anticipated a recession four or five times over the last couple of years," said Harry Papp, an investment adviser at L. Roy Papp & Associates in Phoenix.
How do stock prices behave around recessions? Not well, as you might expect.
During the past nine recessions, dating to the early 1950s, stocks in the Standard & Poor's 500 index dropped a mean average 20.2 percent or a median or midpoint 16.9 percent, according to Asha Bangalore, an economist at Northern Trust in Chicago. In a recent report, she warned investors to "brace yourselves for a rough ride in the months ahead."
Four indicators on which the NBER focuses - industrial production, payroll employment, inflation-adjusted personal income and sales in manufacturing and trade - appear to have peaked in recent months, according to Bangalore.
Whether or not a recession has arrived, many investors are acting like it has. Since peaking in October, the S&P 500 was down about 11 percent through the end of last week's trading.
One key lesson is that the stock market usually peaks and starts moving lower before the business cycle tops out. Similarly, stocks usually bottom and start moving higher before the economy rebounds.
"The market shows signs of improving before the economy does," said Jim Dew, a certified financial planner at Dew Wealth Management in Scottsdale, Ariz.
Investors tend to be about four months early on average, according to Bangalore.
It's not surprising investors feel skittish about a possible recession, considering what happened the last time around. The S&P 500 shed about 30 percent during the recession-related market downturn of 2000-2001, according to Bangalore. Stocks then recovered a bit but slumped further in 2002 before finally embarking on a sustained upward trajectory.
On the other hand, stock valuations were about twice as high going into that slump, based on price-earnings ratios and other measures, than they are now. That could imply a milder market reaction this time around, assuming a recession does in fact materialize.
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