Wealth management Boston

What Happens to the Stock Market After a Recession?

One of the most pressing questions for investors right now is where does the stock market go from here? A recovery following the global downturn in the markets could take many shapes and history can serve as a guide for how long it could take the financial markets to bounce back following a bear market or recession and what returns could look like going forward. Unfortunately, like previous recessions or market downturns, this time is truly different.

Where does the stock market go from here?

In this article for Forbes, Kristin McKenna, CFP® discusses the intersection of history and reality at this unprecedented time in history.

Let’s face it, this is uncharted territory—in modern history we’ve never had to contend with anything like the COVID-19 outbreak and the global economic shutdown that has followed. Regardless, here we are: trying to hold the economy in suspended animation until we get the all clear to go back to old-normal life. It’s still too early to officially declare a recession though it seems like more of a formality at this point. So what can we expect from the stock market after this crisis is over and we can go outside again? What might the recovery look like?

Although the current situation is unprecedented, bear markets and recessions are not. Yes, this one is different, but to be fair the ones before it were too. And they all have one thing in common: they eventually end.

Ready to quarantine the losses

According to Dimensional, in the one, three, and five years following a correction up to a bear market (20% decline from recent highs), the stock market has averaged an annualized return of nearly 10% across all time periods.

Average Stock Market Returns After Decline

(Fama/French Total US Market Research Index Returns, July 1926 – December 2019)

Stock Returns After Bear Market

As you’ve likely heard by now, the U.S. has fallen into the fastest bear market in history: it took only 16 trading days for the S&P 500 to fall over 20% from the high on February 19. March 2020 also made history as the most volatile month for the S&P on record.

From a more optimistic standpoint, the data above shows that after a more severe 20% decline, the average gains in the years to follow were more robust compared to smaller drawdowns.

While this may be welcome news, it’s still important to keep in mind the impact that volatility and the sequence of returns can have on a portfolio, particularly for individuals late in their career or recently retired.

For example, on March 12, 2020 the S&P 500 was down -9.5% only to return following day up 9.3%. While it might look like investors recouped their losses after the second day, an account would still be down -1.1% as there are fewer dollars remaining to participate in the growth the next day. The S&P would have needed to surge 10.5% the next day for individuals to break even in this example.

How long will the bear market or recession last?

We all would love to know when the economy and regular life gets back to normal, but unfortunately, there’s just no way to tell at this point. But when this does pass, there’s a good chance that our recovery will be faster compared to other downturns given the pent-up demand from so many weeks of home isolation. It’s also likely that the longer the shutdown lasts, the slower the rebound will be.

History of bear markets and the recovery

S&P 500 Total Returns from January 1926 – December 2019

History of bear markets and returns on the S&P 500

Source: Dimensional Fund Advisors1

Using the S&P 500 as a guide, it’s clear there’s a wide range for how long bear markets typically last and the drawdown.

According to the Wall Street Journal, taking into account all U.S. bear markets since the mid-1920s, it took an average of 3.1 years for the broad market to recover from where it stood before the bear market began on a dividend and inflation-adjusted basis.

On average, Dow Jones Market Data shows the average bear market wipes roughly 36% off the S&P 500 and lasts for about 7 months. Given the decline from recent highs, it’s no surprise it tends to take a few years to bounce bank.

How long until the market recovers after a recession?

As you know, a bear market (generally thought of as a decline of 20% or more from recent highs) is not the same as a recession (broadly defined as two or more consecutive quarters of negative GDP growth).

On average, the S&P 500 has been up over 15% in the year following a recession. In fact, the index even averaged nearly 4% during the recessions.

Stock market performance after a recession

Source: Ben Carlson

History provides guidance, not answers

It is critical to keep in mind all the various factors at work here. By definition, a recession must last at least six months, where a bull or bear market could last a matter of days in theory. In fact, after 11 trading days, the Dow Jones managed to climb out of bear market territory at the end of March.

Historically, the stock market has bottomed out long before the worst of the economic data unfolded, such as unemployment numbers. So when people talk about whether we are Ôout of the woods’ or not, it’ll depend on your perspective. Your 401(k) will probably begin the recovery process before your neighbors are all gainfully employed again.

Although this article is strictly a discussion on the investment implications of the crisis, we shouldn’t lose sight of the massive human toll, both in terms of illness and the damage to the livelihoods of so many Americans, that has been caused by the virus.

It’s also worth mentioning that there isn’t necessarily a correlation between how severe a recession was from a GDP standpoint and the drawdown in the stock market. For example, during the financial crisis and great recession, annualized GDP growth was ‘only’ -5.1% despite a total drawdown in the stock market of over 50%. But when looked at on an annualized basis, the S&P was down around -38% in 2008 only to finish 2009 up over 23%.

The point is that statistics are a helpful guide, but they only take us so far. Depending on the index you’re looking at, time period, and how many different measuring sticks you use, you could get a different outcome.

The U.S. has never been in this situation before in modern history, so while past downturns offer the only guide as to what might be to come, the truth is that no one really knows. Everyone is just doing their best to interpret the data and constantly changing nature of the virus to adjust and forecast.

What does all this mean for investors?

Given the government stimulus and the cause of the current economic situation—the outbreak forcing businesses to close and workers to stay home—it’s reasonable to expect that the economy could recover relatively quickly once this is all over, though the availability of testing and the status of a vaccine will almost certainly weigh on heavily.

Depending on your life stage, financial situation, and the extent that the virus has disrupted your life, what should you do to prepare for a prolonged downturn will vary.

For most investors, selling investments and going to cash will ultimately be a mistake. Individuals with a long runway before retirement may need to do little else other than periodically rebalance their accounts, though there are other strategies long-term investors could take advantage of, such as a Roth conversion or adjustments to asset location and/or asset allocation.

For individuals in retirement or closer to, other changes could be advisable, again depending on your situation. Cutting back on discretionary spending or even delaying retirement could be necessary, especially if the virus continues to suspend all economic activity. Retiring into a downturn usually is not advisable if it can be avoided.

The bright side is that after falling into a bear market, recession, and even the Great Depression, the market has always recovered and went on to exceed its previous high-water mark. The same is not true for single stocks, which is why we are staunch advocates of diversification across asset classes.

As a country, we will get through this eventually. In the meantime, we all just need to stay inside and focus on what we can control.

Kristin McKenna, CFP® is the Managing Director of Darrow Wealth Management, an independent wealth management firm in the Boston area.

1Chart end date is 12/31/2019, the last trough to peak return of 451% represents the return through December 2019. Bear markets are defined as downturns of 20% of greater from new index highs. Bull markets are subsequent rises following the bear market trough through the next new market high. The chart shows bear markets and bull markets, the number of months they lasted and the associated cumulative performance for each market period. Results for different time periods could differ from the results shown. Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Source: S&P data © 2020 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.

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