Some discussion on recessions and bear markets

According to Bill Montague, Consulting Group Senior Financial Writer, recent 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.

There is no question the U.S. economy is under considerable stress - due to major downturns in many regional housing markets, severe losses on some mortgage-backed investment and a contraction in credit as financial institutions seek to repair their battered balance sheets.

These problems have also spilled over into the larger economy, pushing consumer confidence down and the unemployment rate up. Businesses are also cutting back on inventories, a classic sign of an economic slow-down.

The result has been a deceleration in GDP growth, from almost 5 percent in the third quarter of 2007 to a meager 0.6 percent in the final three months of the year.

Many investors assume these trends will soon lead to a downturn in corporate earnings, which have remained surprisingly robust in recent years despite higher oil prices and a rebound in wage growth.

A full-fledged recession almost certainly would push profits sharply lower, many analysts argue, dragging the stock market down with it. At least that's what investors fear will happen.

However, while such a scenario may be plausible, it's hardly inevitable. In fact, the historical record suggests the link between recessions and bear markets is not as tight as some investors appear to believe.

Over the past 11 recessions (as defined by the National Bureau of Economic Research, a nonprofit research group), the S&P 500 Index posted an average annualized return of 12.1 percent, more than a percentage point and a half higher than that index's 82-year annualized return. All told, market returns have been positive in seven of the past 11 recessions.

Those result may seem illogical, given that recessions usually are bad for corporate profits - 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 percent.

Standard financial theory teaches that the price of a stock should reflect the stream of earnings it is expected to produce. So, everything else being equal, lower earnings should mean lower equity valuations and negative returns.

But all things are seldom equal. Other factors frequently influence stock prices, even during recessions. These forces can include inflation, interest rates, noneconomic shocks, and investor psychology.

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 ten 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 recovery before the economy does, as investors begin to anticipate a rebound in earnings.

While the stock market is forward looking, it isn't a psychic. Many economic slumps widely anticipated by investors - and reflected in stock prices - have never materialized. Or as the Wall Street goes: The stock market has correctly predicted ten of the last five recessions.

At this point, it's impossible to predict whether the current economic jitters will lead to a recession or how the stock market might react if they do. Much would depend on investor expectations about the seriousness of any downturn and their confidence in the long-term soundness of the U.S. and global economies.

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, have often been disappointed.

For most investors, the wisest course it to develop a long-term investment strategy and stick to it, even during market corrections and economic downturns.

Please e-mail me at William.a.creekbaum@smithbarney.com or call 689-8704 for a copy of the full Consulting Group report.

Smith Barney does not provide tax and/or legal advice. Please consult your tax and/or legal advisors for such advice.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Suite. 200, Reno, NV 89509.