There’s bad news — but some good news, too.
We’re probably already in a recession. The U.S. economy contracted for the second consecutive quarter, with the gross domestic product (GDP) falling 0.9% in Q2 after a 1.6% decline in Q1. Having two quarters in a row of GDP declines is widely viewed as the beginning of a recession.
Officially, though, the U.S. won’t be in a recession until eight economists say so. These economists serve on the National Bureau of Economic Research’s Business Cycle Dating Committee.
Investors won’t wait until the official declaration of a recession to worry about the stock market. But how does the market perform during a recession? Here’s what history shows.
An ugly chart
The S&P 500 doesn’t fully represent the entire stock market. It only includes 500 of the biggest publicly traded companies listed on U.S. stock exchanges. However, the S&P 500 has long been viewed as a good proxy for the overall market. And since the index has been around for 65 years, it gives us a way to look at how the stock market has performed in most post-World War II recessions.
There have been 10 official U.S. recessions since the S&P 500 was established in 1957. The following chart shows how the index fared during those periods.
The worst S&P 500 decline occurred during the Great Recession, which began in December 2007 and went through June 2009. The index plunged as much as 55% below its previous peak in March 2009.
However, that was a much more severe recession than normal. The average S&P 500 decline during post-World War II recessions is around 29%. This average is skewed, though, in part due to the especially steep sell-off during the Great Recession. The median decline is around 24%.
Unsurprisingly, the S&P 500 has always dropped during a recession. Many companies report lower earnings as consumers tighten their purse strings. Investors often react negatively to any bad news.
Two important details
There are two important details related to how the S&P 500 has performed during recessions. First, in many cases, the index declined significantly well before the official start of the recession. Second, the S&P 500 frequently began to rebound well before the end of the recession.
The S&P 500’s decline before the start of a recession makes sense. Investors tend to be forward-looking. Most recessions don’t come out of the blue, although the COVID-19 recession of 2020 was an outlier.
Investors usually see the signs of a potential recession well before one is officially declared and often become more cautious in advance. This risk-averse psychology can impact stocks before a recession hits.
But this same forward-looking mentality also helps stocks to begin recovering before recessions officially end. Again, the economic improvement that leads to the ending of a recession doesn’t usually happen overnight.
Investors watch for hints that a turnaround could be on the way. When they see positive indicators, they begin buying stocks more aggressively. This often causes a bandwagon effect, with even more investors jumping into the stock market.
Reasons for optimism
Looking at the past performance of the S&P 500 should give investors reasons to be cautiously optimistic right now. The index is currently down around 18% and was more than 20% below its previous peak just a few weeks ago. There’s not much more room to fall for the S&P 500 to reach the median level of decline during a recession.
More importantly, the S&P 500 has bounced back sharply after every recession we’ve had. And it often began a major rebound well before the end of the recession.
This bodes well for long-term investors. The current market downturn should provide an excellent buying opportunity for anyone with the patience to hold on for a few years. That’s true whether a recession is really on the way or not.