Investors shouldn’t fear recessions, as history suggests it is not unusual for them to earn high single-digit annualised returns in the two years after the start of any downturn – so long as they hold their nerve.
Spiralling inflation has led to a cost-of-living crisis and fears of a recession. The FTSE All Share tumbled 4% in a matter of days earlier this month after the governor of the Bank of England Andrew Bailey warned of a “very sharp slowdown in activity”.
However, Mamdouh Medhat, senior researcher at Dimensional Fund Advisors, has studied economic and market data in the US going back almost 100 years, and said the overwhelming lesson is that long-term investors shouldn’t view an approaching downturn as a sign to sell out.
“Bull markets have far outshined bear markets in terms of duration and performance. So, even if economic conditions deteriorate and markets fall in 2022, investors can still expect a positive return in the future,” he explained.
Since 1926, there have been 15 recessions, 18 bull runs and 17 bear markets in the US. This encompasses periods in which it endured wars, a depression and a pandemic, in addition to economic, political and financial crises.
In 11 of the 15 recessions, stock market returns were positive over the next two years. In addition, the potential gains outweighed the losses, with equities delivering average annualised returns of 7.8% in the two years after each recession.
“The reason is, of course, that market prices are forward-looking: by the time economists officially declare a recession (based on recent GDP growth or similar), the market has often long-since reacted,” said Medhat.
“So, while it might be intuitive to link a recession with poor stock returns, the data does not support this intuition.”
Source: Dimensional. Past performance, including hypothetical performance, is not a guarantee of future results.
While the data is on the side of investors, Medhat accepted that is of little comfort to them at the time of a downturn. For example, while we have yet to even enter a recession, the expectation of one is just as unsettling, as is evident from the performance of markets this year.
Ignoring the impact of currency movements – the strengthening US dollar has alleviated much of the pain for UK investors abroad – the MSCI World index is down 13.6% and the tech-heavy Nasdaq-100 is down 23.9% – putting the latter firmly in bear market territory.
“When combined, talks of a recession and volatile markets can lead investors to question their long-term strategy,” Medhat continued.
“Nonetheless, if you’re considering whether this is the time to move out of equities, you should remember the risk of mistiming your move out of the market and back into it. Most of the time, simply staying invested has rewarded investors.”
For example, he pointed out the 17 bear markets (drops of at least 20% from the prior peak) in the US between 1926 and today resulted in falls of -21% to -80%, and lasted an average of 10 months. He compared this with the 18 bull markets (gains of at least 20% from the previous trough), which lasted an average of 55 months and made returns of between 21% and 936%.
“The stark difference in performance and duration is made clear in the chart below. Bears are scary but, over time, bulls have always beaten them,” Medhat added.
Source: Dimensional. Past performance is not a guarantee of future results.
“If you take the view that markets do a good job of incorporating information into prices, you can consider prices as the most complete predictions of the future. Stated differently, markets continuously look into the future and adjust current prices to reflect aggregate expectations about future returns.”
He pointed out this was true for bonds as well as equities. For example, gilt yields have risen this year in expectation of rate hikes. Importantly, Medhat noted this happened well before the Bank of England’s announcements.
The analyst added that while the stock market’s ups and downs were unpredictable, the overall trend is up over the long term.
“Suppose that a hypothetical investor had put $1 into the S&P 500 index at the beginning of our 100-year sample period,” he said.
“She might have needed nerves of steel to endure the recessions and bear markets that followed, but would have been rewarded generously: her investment would have grown to $14,076 by the end of 2021.
“The conclusion we draw from this is simple: staying the course gives you the best chance of enjoying the benefits the market can offer.”