Do stocks bounce back after a recession?

They do, but that may not be as interesting as it sounds.

Many advisers have recently circulated a chart illustrating how the stock market recovers. Though each company has added its own touch, the original data come from Ned Davis Research, Inc.

Here is one version from Charles Schwab:

source

The data seem impressive. Here are some conclusions advisers have made:

• The last 10 recessions indicate stocks bounce back
• In fact, stocks grew an average of 32 percent one year after the market low
• Investors that sold and later bought back missed out on the growth
• Recessions can be buying opportunities

While these conclusions sound sensible, one should take them with caution. There are some issues with the data and here are some of my reservations:

At a market low, there is nowhere to go but up!

The chart is misleading because all returns are taken after a market low. That is, we’re looking back at the absolute lowest point during a recession and then asking “what happened after that?”

Of course, the market had nowhere to go but up! Saying the market gained after an absolute low is nothing interesting-it is a pattern we expect.

I am reminded of Yogi Berra who said, “I always thought that record would stand until it was broken.”

In practice, we can never be sure when the market is at its low. That is something we can only see in hindsight.

The harder you fall, the harder it is to recover

A 32 percent gain sounds nice, but is it enough?

One has to be careful when accounting with percentages. Suppose you lose 50 percent on a $1,000 investment by the market low. You only have $500 at this point. That means you’d need to double your money-a 100 percent gain-just to break even.

The issue is that after a market loss your invested value is lower. Therefore, you’ll need a higher percentage return on this devalued base to break even.

Here is a small table comparing the losses and gains. The bigger the loss, the larger the gain has to be:

*gain = 1 / (1 – loss) – 1

As markets might fall anywhere from 20 to 50 percent before a market low, getting a 32 percent return may not even be enough to break even. So keep the bounce back in perspective.

Past performance is not predictive of future results

The 2001 recession stands out in the chart of stock returns. Before that, the previous 9 recessions all had positive returns for every three-, six-, nine-, and twelve-month period. But the 2001 recession did not illustrate the same bounce back. One year later the S&P 500 had fallen by another 14 percent.

It is up to you to be skeptical of the data. Advisers will try to downplay the 2001 data point by referring to the mean or median 12-month return. But again, these is no reason these values will have predictive value.

In conclusion

Past data should be viewed with proper caution.