This is a topic I wanted to cover for quite a while and I think this is the perfect time for it: I got a few posts lined up already dealing with the intersection of macroeconomics and (personal) finance. Of course, I can already hear one objection:
“Oh, come on Big ERN, did you see the volatility in the stock market last week? My portfolio went down by 10+% since the January 26 peak and you want to talk about macroeconomics now? The first week of February 2018 proves that the macroeconomy doesn’t matter for stocks!”
And my response: Yes, this is actually the perfect time to talk about macroeconomics! See, the main reason I was not overly concerned about the market volatility earlier this month is that the economy seems to be running just fine and there don’t seem to be strong signs of any impending recession. Of course, the stock market has some wild swings, sometimes during a recession, sometimes outside of a recession. But all the really bad disasters, the bear markets that sunk retirement dreams in my Safe Withdrawal Rate historical simulations, they all occurred during recessions. And not just any minor garden-variety recession but the big ones! In other words, this is how I insist macroeconomics matters for the stock market:
What do we make of a 10% drop in the stock market? It’s a buying opportunity during an economic expansion! But during a recession, the market might potentially get a lot worse before it gets better!
And in today’s post, I like to provide some empirical evidence for my view…
Normally, people look at the historical returns post 1926 (see Ben Carlson’s post for example) rather than going back all the way to 1871. I figure the idea is that if we go too far back beyond 1926 the economy and the monetary policy response would become less comparable to today’s economy. So let’s plot the cumulative equity return during the last 92 years, starting in January 1926. As always, I use real CPI-adjusted S&P500 Total Returns (incl. dividends) and this is all plotted on a log-scale to make comparisons easier. I also include the U.S. recessions shaded in orange. See chart below:
Notice how there were even some (brief) recessions where the stock market advanced. There were also some wild swings during economic expansions (think 1987). But nevertheless, all of the really deep and extended stock market meltdowns occurred during recessions. Why does this matter? When I saw the stock market swings last week I wondered what regime we’re going to be in; is this the precursor to a recession or just some market volatility that just simply happens every few years? The economy seems to be doing just fine (how I reached that conclusion is a topic for a future blog post) and I concluded it’s probably not the time yet to run for the hills and sell equities. Quite the opposite, last week, I funded our IRAs for the 2018 tax year and I bought more FUSVX!
Another chart I always like to look at is the “drawdown chart,” i.e., plot how far the market fell below its previous all-time high. Why does a drawdown chart matter? Think Sequence of Return Risk! I have written extensively on the topic (see Part 14 and Part 15 of the SWR series) and also did an entire podcast episode on ChooseFI about the topic. Deep drawdowns mean that retirees are taking money out of the portfolio at discounted prices. That’s bad for the long-term survival prospects of the portfolio! The exact same way dollar-cost-averaging sometimes helps the saver, the retiree loses from an extended market downturn early during the withdraw phase! In any case, you obviously get some drawdowns during economic expansions. But the drawdowns are only moderate, around 10-20% (30% once during 1987), and they are very short-lived. But the really traumatic, deep and extended drawdowns always occur during recessions. And of course, sometimes the recovery and the path to the new all-time high will take years and extend for years into the next expansions.
Not only that, some recessions were so bad that the new all-time high wasn’t even reached until after the succeeding recession:
- The peak of 1929 before the Great Depression was not reached until 1945, i.e., after the 1937 recession.
- The pre-1973 high wasn’t reached until after the 1980 and 1982 recessions.
- The pre-2001 high wasn’t reached until after the 2008/9 recession. (and again, that’s because I plot real/CPI-adjusted returns. In nominal terms the market had recovered in 2007!)
And do we all notice what these three episodes have in common? The first two are the classic examples of when the 4% Rule failed (both over a 30-year horizon and most definitely for a 60-year horizon). And the third episode? Well, the jury is still out on that one but I’m not too hopeful, see a case study I did a year ago.
And finally, here’s another chart to drive home my point: Here’s the cumulative return during the roughly 75 years of expansions (black line) and the roughly 17 years of recessions. Think of this as plotting the cumulative return chart once by splicing together the white shaded regions (i.e., expansions) in the chart above and once by splicing together recession portions only:
It’s a different chart, a different way to present the same data but the same story: The macroeconomy matters a lot for stock returns. +11.44% average real return during expansions and -11.32% during recessions. But I’m the first person to concede that 15.61% annual volatility during expansions and monthly returns ranging from -23% to +42% can still look pretty wild. But again, during expansions, we have a 62%+ share of positive returns and significantly more attractive returns than during recessions!
How is this analysis different from Ben Carson’s calculations?
You might have seen the post about stock market performance around recessions on Ben Carlson’s site A Wealth of Common Sense. He makes it sounds as though recessions don’t really matter so much for the stock market. Of course, I use the exact same data but only present it differently. (OK, for full disclosure, I use real inflation-adjusted returns, which I find more comparable across time, while he uses the less informative nominal returns.) And I think my way of presenting the data makes a pretty compelling case for a strong link between macroeconomics and stock returns. For example, he (correctly) notes that there have been a few recessions where the stock market advanced. I don’t disagree with that but I just think that this it is a red herring and it distracts from the more meaningful hard numbers I provide.
But, but, but … it’s difficult to declare recessions in real-time!
“Economists are almost always slow to spot key trouble signs. […] Remember the Great Recession that began in December 2007? The economists at the National Bureau of Economic Research, who are basically the official scorekeepers of recessions, didn’t discover the recession until December 2008 – a year late, and only a few months before the episode (officially) ended.”
The NBER business cycle dating committee is so late in declaring the macroeconomic turning points because they want to be 100% sure when they call the recession start and end. Even though everyone already knows the recession has started/ended if there is still some residual uncertainty about what exact month it was the NBER will not make their official statement. Take the following analogy: the U.S. Presidential election. We all normally know the election result on the evening of the election (or the early morning hours of the following day) but it takes another formal vote in the electoral college, and then until January 20 of the next year until the new president is actually sworn in. The NBER waits until the recession is “sworn in” while everyone else already knows with 99.9% certainty that the economic turning point has occurred. For example, economists definitely monitor the economy in real time and there is actually a whole “industry” in economics trying to estimate NBER recession probabilities in real-time before the actual announcement is made. It’s actually something I would occasionally do in my day job!
Chill out, everybody! The big drop last week wasn’t so bad! Volatility will probably stay with us for at least a few more weeks. Maybe months. But to me, it looks less like the beginning of another Global Financial Crisis and more like another false alarm like 2011 (U.S. downgrade), 2013 (Taper tantrum), 2015 (Chinese devaluation), Jan/Feb 2016 (Fed rate hike jitters) and June 2016 (Brexit). And I probably forgot a few other events that were paraded as the end of the world over the years.
Of course, I haven’t really told you why I think the economy is way too strong for me to be concerned about a recession right now. That will be the topic for an upcoming post. Blogging 101: always put in a cliff-hanger at the end of the post to make the readers come back. And while we’re talking about cliff-hangers, I also got a fun new joint venture with a fellow blogger, Actuary on FIRE, about the impact of inflation on early retirement! That will be a multi-part series and AoF will post part 1 on his blog next week. So, stay tuned for that one as well!