At first glance, you would probably assume that markets go down in times of recession and up when economies grow. In theory, this is correct but not necessarily on the timescale you might expect, and the performance in times of recession and economic growth can be very different. Let’s explain.
How do stock markets work?
Before we look at performance in times of recession and economic growth, it is crucial to recognise how stock markets work. Basically, the level of any share price is based on the value of the underlying company. However, is that the value today, tomorrow, six months or further down the line?
While there are different opinions, you tend to find that stock markets value individual companies (and their share price) on their prospects anywhere between nine months and 12 months into the future. The perceived value of the company relates not only to their underlying trading and prospects going forward but also to local and global economies. There’s a lot to take in!
Stock market performance
Following on from above, have you ever wondered why stock markets tend to fall before we, as consumers and businesses, feel the economic pinch in our pockets? This is because they are looking in advance at interest rates and prospects for the future and pricing assets on that basis. Conversely, sometimes the economy can feel depressed, but stock markets are rising because they are looking to the future.
Many stock markets and individual price trends are based on the premise that history does repeat itself, although sometimes to a lesser or greater extent than previous. So, when looking at recessions and times of economic growth, it is better to look over a prolonged period.
Economic data
As we know, economic data has a significant impact on stock market performance in times of recession and times of economic growth. An in-depth report by Capital Group looked into the “average” period of recession and expansion in the US economy to help understand how markets might react.
Probably not what you expected, the research found that over the last 70 years:-
- The average period of economic expansion lasted 69 months and saw GDP growth of 24.6%, with 12 million net jobs created
- The average recession lasted just ten months and saw GDP growth of -2.5%, with net job losses of 3.9 million
The outstanding figure is the average length of periods of expansion and recession, suggesting, as we see with historical stock market data, prolonged periods of upside compared to downside. This does not mean that the next downturn will only last ten months or the next period of expansion more than five years, but it does give you a general idea.
Does a forward-thinking approach reduce stock market volatility?
Theoretically, stock markets and stock prices are a combined reflection of the opinions of investors, analysts and other experts – across a broad range of subjects. Even elements of political or stock bias will be diluted due to the amount of input from different parties. Compare this to the opinion of politicians and governments worldwide, who have an obvious bias, and you find why many people look to the markets for future trends rather than politicians. So, can we rely on the forward-thinking approach of stock markets?
Stock markets will value individual shares on the prospects for the companies and economies as they stand today. As nothing is ever set in stone, individual company or economy prospects, or both, could change tomorrow, which would prompt a revaluation. When it comes to broader economic prospects and the time lag between, for example, interest rate movements and economic performance, as well as the myriad of indicators, there are typically fewer shocks.
Consequently, there tend to be more shocks and surprises, on the upside and the downside, with individual companies.
Summary
The structure of the stock market can be as complex or straightforward as we would like to make it. Ultimately, it boils down to supply and demand and prospects for the future, both in terms of companies and economies. The fact that periods of economic growth tend to last much longer than recessionary times suggests that as investors, we are more cup half full than half empty, with sentiment playing a considerable role in stock markets and economies.
The fact that stock markets look forward, arguably nine months plus, explains why markets often move in a different direction from the economic headlines we see today. If you would like to review your investments, please contact me today, and we can look at the options going forward.