If It's a Recession, Stocks Have Much Further to Fall
The stock market started 2016 with its worst first two weeks ever, renewing a decline in stocks that began around mid-2015. In mid-December, the Fed indicated its confidence in the economy's expansion by finally raising the policy interest rate above zero. Does the falling stock market reflect signs of economic trouble that the Fed missed? What relation is there between stock prices and the economy anyway?
Economists like to cite Paul Samuelson's long ago quip that the stock market had predicted 9 of the past 5 recessions. It neatly summarizes the much greater volatility of the stock prices and warns against relying on the market as a forecaster of the economy. But it also says the stock market predicted the five recessions that did occur.
Going beyond Samuelson's sample, what does the experience over the past 50 years show? It remains true that most stock price declines that alarm investors are false alarms as warnings of recession. However, big market declines are a different matter. Wall Street defines a bear market as a decline of at least 20 percent, and by that definition there have been seven bear markets in the past 50 years. The three biggest, ranging from declines of 48 to 57 percent in the S&P index, were associated with the recessions that began in 1973, 2001 and 2007. Bear markets also came with the recessions beginning in 1981 and 1969. So the correlation between big market declines and economic recessions is pretty high. Only the bear markets in 1966 and 1987 were false alarms.
So does today's stock market decline, which is about half-way to bear market territory, reflect a weakening economy? The preliminary GDP estimates for the fourth quarter, which were released on Friday, showed real output grew at an annual rate of just 0.7 percent. But the picture is less alarming when disaggregated by sectors. Weakness abroad hurt exports and falling prices for commodities, especially oil, hurt business investment. Some of this activity should bottom out soon, especially if oil prices stabilize. By contrast, consumer spending and residential construction were strong in the fourth quarter and their expansion is likely to continue. Real disposable income last year rose by 3.5 percent, and private sector employment, the most robust measure of economic activity, grew by an average of 211,000 a month in 2015, and by 275,000 in December. That does not indicate a weakening economy that would call for a bear market in stocks.
What about economic issues that are not apparent in such macroeconomic data? The slowdown in China's economy is much in the news and not well understood. But we export little to China so its effect on output here is minor. Oil prices are more important and many observers believe the oil sector poses special economic risks that go beyond the decline in investment spending by drillers and related industries. Defaults on borrowing by U.S. shale producers are soaring. But while the bankruptcies in the oil patch are a serious matter within the industry, they represent conventional lending risks, reflected mainly in declining prices in the high yield bond market where much of this debt resides. There is no reason to believe this debt presents any important systemic risk.
The U.S. economy continues to be an engine for world growth, and the reasoning above suggests the economy will pull the stock market up from its present slump. Policymakers agree. At its recent January meeting, the Fed stressed that it is continually assessing the global risks to its forecast. In today's uncertain world, that is the best we can ask for.
As for stock market investors, history shows the best advice is buy and hold because stock markets are too volatile to forecast. It also shows that every recession has been accompanied by a bear market. If, contrary to the assessment offered above, you are somehow convinced you can forecast the economy is heading into recession, stocks have a lot further to fall before reaching bear market territory.