Why The Stock Market Drop Does Not Predict Recession

The stock market has fallen 18.7% since its peak Jan. 3. Investors often define a bear market as a 20% drop from a peak, so we are close enough to smell the bear. Does the stock market drop foretell a recession? It turns out that stock market declines are poor indicators of upcoming recessions. Understanding this helps our understanding of investments as well as the economy.

Here’s a quick summary of the stock market for the recessions since 1950, using a 20% decline in the Standard & Poor’s 500 index as an indicator of upcoming recession (based on month-end values for easy calculations).

The stock market did not drop this much from its previous peak around the recessions of 1953, 1957, 1960, 1980, 1981 or 1990. The stock market turned bear at the same time that the 1970 and 2020 recessions began, so it provided no early alert. It provided one month of advance notice for the 2001 recession. The stock market was three months late in its warning of the 1973 recession and eight months late in 2008. False warnings came in 1962, 1977 and 1987.

Obviously this is not a great way for business leaders to anticipate overall economic downturns. But perhaps the 20% decline from the previous peak is too strict a criterion. We could try 10% declines. Here’s what that threshold shows.

No advance warning came for the 1980 recession. The 1952, 1981 and 1990, 2008 and 2020 recessions had simultaneous signals, so no advance warning. Advance warning came one month before the 1960 recession, five months before the 2001 recession, six months before the 1970 recession, and seven months before the 1957 and 1973 recessions, False alarms occurred in 1962 and 1962, 1971, 1984, 1987, 1998, 2018.

Although this is not a great track record, a sharp decline in the stock market is worth paying some attention to.

Why would the stock market drop if not for an upcoming recession? A good start for analysis is the dividend discount model, in which a stock’s value equals expected future dividends discounted for the time value of money. The current value of a stock, denoted V₀, is given by:

where D denotes the expected dividend in a particular year and r denotes the interest rate. The divisors, (1+r) raised to a power, reduce the dividends to reflect the time value of money.

What could cause the value of a stock to decline? Suppose that most investors expected dividends to grow by 10% per year. Then they revised their thinking to just 8% annual growth. That’s still consistent with an expanding economy, but it’s not as strong as the earlier assumption. The stock value would drop. Another cause of a stock market decline could be a rise in interest rates even if they don’t affect future dividends. With higher interest rates, money in the future has a lower value than it used to, so stock prices would fall. This is in addition to a possible decline in dividends that rising interest rates might trigger.

In addition to the dividend discount model, many other analytical approaches can be used to estimate stock values, but with the same conclusion: there are plausible reasons for stocks to fall that do not involve recession.

Let’s not forget emotions. People will sometimes get spooked by political events, business headlines or other news. So a stock market decline doesn’t necessarily tell us what is happening in the world of spending, production and employment. The stock market may be worth paying attention to, but its signals are quite fallible

Does this review of the data prove that the economy is not in for a recession? Nope, a recession is certainly possible. Interest rates are rising, energy costs are up, and some consumers cannot keep up with their recent spending given inflation running higher than wage growth. However, the economy is still feeling the benefit of past stimulus, both government spending and easy monetary policy. Stimulus works through the economy over time, and we are still enjoying the benefits of last year’s money creation.

The change in monetary policy will be felt mostly in 2023, and even then it will be a gradual change. Recession is much more likely in 2024 than this year or next, but even then not a certainty. The Federal Reserve may chicken out of its inflation-fighting stance when employment weakens. The time lag between monetary policy’s effects on employment is about half as long as the time lag to slowing inflation. So next summer, the Fed will see it’s tightening slowing job growth but doing little to limit inflation. That’s high noon, when we learn the character of the Fed’s decision-makers. The most likely course is that the Fed continues to fight inflation, but if they waver, then no recession in 2024. But if they do waver, look for a doozy of a downturn when a latter-day Paul Volcker is eventually sent in to do the job.