Do Recessions and Bear Markets Always Go Together?
Fresh off his remarks about how we need to raise the wealth tax much higher than proposed, Bernstein’s Philipp Carlsson-Szlezak leads us in a discussion about bears.
There are surely many people who think that bear markets and recessions simply go together, where a bear market will mean a recession is going on and a recession will also cause a bear market. Bernstein economist Phillip Carlsson-Szlezak has pointed out, and rightly so, that the two don’t necessarily go together and that we have to look at each situation individually.
We always want to go deeper than others tend to though, to look seek to understand things better, and especially when people bring up topics such as this that aren’t usually discussed. The correlation between bear markets and recessions is one of these infrequently discussed areas, and people worry about both situations quite a bit, so this is therefore something well worth examining in more detail than usual.
The prices of stocks, either individually or en masse with stock indexes, move up and down all the time, year by year, month by month, week by week, day by day, hour by hour, minute by minute, tick by tick. There are a number of things that cause these up and down movements, with some being more significant than others, so the trick if we’re worried about a bear market is to be able to try to figure out what is meaningful and what is not.
To do this, we do need to develop at least a decent understanding of why stock prices move the way that they do in the first place. There are a lot of things that we might think speak to this, economic growth for example, but this in itself doesn’t determine where the market is going, although it does influence the mood to a certain degree.
There are two main things that influence stock prices on a fundamental level, along with a lot of other things that may influence these two main factors to some degree but are always dependent on it. If we just look at what we could term the secondary influencers, such as economic growth or contraction, and this is a factor that does influence things but only to a certain degree, we’re not going to really understand things very well.
The two fundamental influencers are quantitative and qualitative market forces. Quantitative market forces are easy to understand and measure, as this has to do with inflows and outflows of capital into stocks. Together, this forms what we call market sentiment, the tendency for the market to want to raise or lower stock prices.
A stock can have a net inflow of capital and not move up very much, or have a net outflow and not move down very much, depending on what is going on with the second fundamental factor, the qualitative side.
We tend to think that the quantitative side is what really influences things, and it does, but not by itself. A very good example of how the qualitative side can rule by itself would be with gaps in either direction, where a stock may open up a little higher or lower and both may only involve only100 shares trading hands initially.
In reality, the price can even move without any trading going on at all, where the first trade of the day gets traded at the higher or lower bid and offer prices that the market experienced by way of events that happened outside of market hours. This also happens during market hours as well, as prices can leap instantly when we get certain types of news that affect the qualitative side of things.
The quantitative side does affect price as well though, and we only have to think of someone looking to buy or sell a very large order to understand how this works. There is only so much inventory at the current price, often 1000 shares or less, and once that gets traded, if you still want to buy, you have to pay the next offer up, or if you are selling, you have to do so at the next bid down.
As we take out these existing levels, this naturally moves the price, and therefore over time, increases on the quantitative side will move prices to some degree. The qualitative side has to do with people’s expectations of price, and the recent example with Biogen demonstrates this pretty well.
Biogen was trading at around $329 a share back in mid-March, when the news hit that they were withdrawing one of its drugs, which they claimed didn’t work, and no longer were going to submit it for approval by the FDA. A few days later, it was trading at $216. This did not happen because all of the bids were taken out all the way down there, but because the bids themselves dropped off the table due to a lesser perceived stock value.
On Tuesday, Biogen announced that they have new data that makes getting this drug approved more promising, and this caused the stock to open up at $310 from the previous day’s close of $223. We have not made it back to where we were in March, because there are still some questions about how viable this will be, but we made it back a long way in a single moment.
People are wondering whether we have priced in this new news too much, perhaps by crunching some numbers and coming out with a lower valuation, but the amount that the market has priced in is what they have priced in, just like the amount it subtracted back in March was the amount it wished to.
Lots of Things Influence Stock Prices, But They All Can Be Measured by Price Change Itself
These moves are the result of the sum of all factors being considered, and it doesn’t even make sense to say that it can be too much or too little, as this is the only thing that drives prices, the expectation. It doesn’t matter how invalid we think that it is, it simply is expressed as fact.
We can predict that people will have second thoughts about their valuation soon afterward, and in this case this view would have been correct, although it’s a known fact that gaps up like this often involve profit taking and this will take some of the edge off the optimism, which happened later that day.
When it comes to looking at economic growth, the last decade has given us a time where economic growth has been its lowest in history over a 10-year period, and this decade has been fabulous for stocks. Even the Great Depression decade saw more growth on average, and it took 25 years for stock prices to recover in real dollars.
When we realize just what moves prices, which we could call the sum of beliefs about what stock prices should be, we are then free to cast off all the misconceptions that we may have about anything else mattering. Things can influence beliefs, but they will only affect stock prices to the extent that they affect beliefs.
Carlsson-Szlezak does provide us with a few examples of recessions and bear markets not correlating, although they still do tend to correlate pretty well on the side of recessions bringing on lower stock prices. The reason is that people generally believe that stocks are worth less when a recession is going on, and this belief becomes reality like it always does.
The first example he mentions is the slight recession of 1990. We actually ended 1990 with positive growth overall, but the second half of the year got us officially into recession territory with back to back quarterly losses.
The stock market did dip by 16% during this time, not enough to qualify as an official bear market, but this was barely a recession and the move down was still pretty significant in relation to it. This does not show the lack of correlation between recessions and market pullbacks though and this move was very well correlated in fact, and therefore we really can’t genuinely count this as counter-evidence just because a slight dip in the water produced a big wave but not quite the one a bear would make.
The recession becomes announced or is looming, people’s beliefs about how high stocks should be priced gets altered, and this puts their price down. Later, when the beliefs change, we move back upward.
Carlsson-Szlezak does claim that a third of the time when we get a recession, we do not get a bear market, and given that this is one of the third that do not count, and one prominent enough to mention as a prime example, this demonstrates how getting hung up on the number 20 can muddy the waters.
We may want to instead claim that the size of a recession may not be sufficient to get to 20 but still may do some real damage, as was the case here, and we may then therefore want to look at not just recessions but also look to their magnitude or probable magnitude to measure the risk.
His example of 1987 is a much better one, although this one shows that we don’t need a recession to get a bear market. In the latter part of that year, we lost 33%, and economic growth was just fine at 3.5%, and you have to go all the way back to 2005 to see a number this big in today’s world.
People mention a number of things when they look to explain the bear move of 1987, but the number one reason is deemed to be market sentiment, with all of the other factors relating to changes in market sentiment.
With a recession, market sentiment also steps in and does the same thing, so the conclusion here should be that market sentiment causes bear markets and a number of things may weigh in on this sentiment to depress it.
Things Move Faster Now, So We Need to Be Faster Too
Carlsson-Szlezak refers to the bear move last year as a matter of the “modern volatility regime,” which is another way of saying that market sentiment is more volatile now than in the past. He expects that the next bear market may come by way of this new regime, and volatility is certainly more pronounced these days due to the nature of trading today versus the past.
We value stocks more quickly, and it wouldn’t be hard to argue that we do so with more force and passion than we used to as well. The way that Donald Trump has shaped the stock market this year is a good example of this, and we certainly did respond in a more volatile way to his remarks than we may have expected, but our sentiment is just that much more liquid now, much like shaking a bottle of liquid is compared to one filled with a semi-solid.
We do need to be seeking a better conclusion here than bear markets and recessions only going together two-thirds of the time, as that’s not particularly helpful to know. If we get a bear market, whether or not we’re in a recession doesn’t matter at least to the stock market, and while we observe it on the ground writhing in pain, why we got struck down does not help us in the present.
If we are in a recession, according to Carlsson-Szlezak, two thirds of the time the bears will be along for the ride, although they either are or they are not. None of this, therefore, has any real predictive value, because the judgements only come down after the fact.
There is a common thread here which can actually help us predict these things, and that’s by looking at market sentiment itself. We have a very clear and easy to do this and that’s to look at the end result of this sentiment and changes in it, which are changes in stock prices itself.
This should be so obvious to have us wondering what else there would be to look at, although many people look at all sorts of other things to look to predict stock prices, with varying degrees of accuracy. These predictions cannot come true without their becoming manifest in the market though, and therefore at a minimum, we need to keep our eye on the market to see if our predictions are even starting to manifest in the real world.
Price is how we keep score with stocks, including determining and measuring bear markets. Declining market sentiment ultimately causes bear markets, and while we can’t predict everything, and get hit with things like Black Monday in 1987, even this move had a progression and the people who were paying attention that day or had the right stop loss orders in place did limit their losses.
We still need to look upon the sky to see how the weather may be forming, but when we do, we see neither a recession storm nor a bear market storm forming. The two don’t always go together, but once we see the rain fall and everyone running inside, it doesn’t matter.
We can try to predict this weather but no matter what our forecast, we need to also keep an eye on how these patterns are developing in front of our eyes to get any sort of real picture. We also need to keep our eyes on what matters, which is changes in sentiment, because that’s what brings on the rain every time.
Editor, MarketReview.com
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