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Does a Recession Cause a Stock Market Drop? What came first, the chicken or the egg? This classic cause-and-effect problem also applies to economic questions—for instance, does a recession cause a stock market drop, or do falling stock...

By Eric Rosenberg

entrepreneur daily

This story originally appeared on Due

What came first, the chicken or the egg? This classic cause-and-effect problem also applies to economic questions—for instance, does a recession cause a stock market drop, or do falling stock prices cause a recession?

When there's a recession, everything in the economy declines as unemployment rises and consumers are less willing to spend money. Even the fear of a recession can cause the stock market to drop as consumers preemptively reduce spending and companies anticipate lower earnings. With that in mind, we'll say right away that recessions can cause stock market drops, though the reverse is sometimes possible.

Key Takeaways

  • The stock market is forward-looking and will often drop before a recession starts and start recovering before the recession ends.
  • Not all companies are impacted equally by a recession since consumer spending won't decrease in every industry.
  • Every recession has had different causes and lasted for varying lengths of time. There's also no general timeline for how long a recession will last.

How Can a Recession Cause a Stock Market Drop?

How do we go about answering this question? One approach is to look at past examples and their order of events.

Some people point to the fact the stock market has always fallen before analysts formally call a recession as proof the former causes the latter, but it's more complicated than that.

Because the stock market is forward-looking, it's always trying to price in what will happen in six to nine months. The NBER calls recessions by looking back at market data and finding a consistent downturn. To better understand the relationship between these two economic scenarios, knowing how they've historically interacted is essential.

What is a recession?

A recession involves a period of negative economic results, often defined as two consecutive quarters with negative real GDP. The official definition of a recession, according to the National Bureau of Economic Research (NBER), is "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."

This definition is helpful because it reflects a recession's widespread impact on the entire economy, from the stock market to real estate prices. And while GDP is a lagging indicator of the economy, the stock market is a leading indicator, meaning you'll feel the pain from an economic downturn in your investment portfolio before you do anywhere else.

Since a recession is often the consequence of imbalances built up in the economy that have to be corrected, stock prices will go down until balance is restored and we get to the next stage of the economic cycle.

A Historical Look at Recessions from the NBER

While the thought of a recession can be terrifying to many, it's critical to look back at previous recessions and their impacts to gain perspective. Every recession has had unique circumstances and lasted for varying lengths of time.

Here's a brief look at the past eight recessions according to data from the NBER.

2020: The global pandemic immediately triggered this recession, lasting two months, from February to April 2020.

2008: This recession lasted from December 2007 until June 2009, a total of 18 months.

2001: The dot-com bubble burst, causing this recession which lasted from March to November of 2001, a total of 8 months.

1990: This recession happened around the time of the Gulf War and lasted eight months, from July 1990 to March 1991.

1981: This double-dip recession was a rare part two, following up the previous year's recession and lasting for 16 months, from July 1981 until November 1982.

1980: This was known as "The Iran and Volcker Recession." It lasted for six months, from January 1980 until July 1980.

1974: This recession lasted 16 months, from November 1973 to March 1975, and was fueled by the Arab oil embargo.

1970: This recession lasted from December 1969 to November 1970, a total of 11 months. Before this, military spending had increased in the 1960s due to US involvement in the Vietnam War.

As you can see, anything from global conflict to rising commodity prices can spark a recession as the economy needs its balance restored. There's also no general timeline for how long a recession will last, though the average length is about ten months.

What Correlation Do We Observe Between Recessions and Stock Market Drops?

During a recession, the stock market is volatile as share prices go through extreme swings due to investors reacting to both positive and negative news. Many investors will start to sell shares to liquidate assets and hold on to cash if they fear further portfolio losses.

A recession doesn't always coincide with a bear market (often defined as a drop of 20% or more from the market peak) because the stock market could be bouncing back by the time a recession is officially called. If we look back at the last eight recessions, we observe no set rule for how long it will last.

There have been ten official US recessions since the S&P 500 was founded in 1957. The worst S&P 500 decline happened in March of 2009, when the index dropped as much as 55% from the previous peak. The S&P 500 drops during a recession because companies have lower earnings due to decreased consumer spending. Investors then react negatively to this news by continuing to sell shares. This creates a vicious cycle, a downward spiral of market damage.

It's important to remember that not every stock will be impacted by the recession equally. Companies in health care, consumer staples, and utilities will tend to do better than other stocks (technology or growth stocks) during a recession. This is because the fluctuations in demand aren't as intense. Even if the stock market is down, consumers need basic staples, health care, and utilities.

Optimism and pessimism affect the market

It's undeniable that the way consumers view the economy influences the behavior of the stock market. When the economy is booming, consumer and business spending increases and businesses improve profits. When companies report higher earnings, their stock prices naturally increase as investors are more optimistic.

Conversely, when the economy slows down – for example, due to rate hikes instituted by the Fed to fight inflation – consumer and business spending starts to decrease, which hurts profits, causing stock prices to go down.

Historically, the stock market bottoms out after the start of a recession. Then the stock market rallies before the economy goes up.

Will There Be an Official Recession Called in 2023?

Why hasn't a recession been called yet? The mixed economic data has prevented an official recession announcement. The National Bureau of Economic Research (NBER) has decided that we're not officially in a recession just yet. This has only fueled interest in the topic in the media.

Most experts agree the NBER will likely call a recession at some point in 2023, but others still contend we will avoid one altogether. It's difficult to say how the economy will shape over the next year as many factors are involved.

Experts believed the positive news surrounding the labor market and resilient consumer confidence in 2022 would keep the economy strong. Others are concerned that further rate hikes from the Federal Reserve would push the economy into a recession.

In February of this year, economists at the International Monetary Fund (IMF) said they expected the US economy to narrowly avoid a recession. However, it's worth noting that many factors impact the economy. As we've all seen in recent years, you never know what can pop up.

We don't know how the economy will be able to perform for the remainder of 2023. Further rate hikes would likely drive down discretionary spending and business performance, which may be necessary to curb inflation. We'll closely watch labor reports, inflation data, and other economic indicators to anticipate the NBER's decision in the coming months.

How Should You Be Investing During a Recession?

A recession or fear of one shouldn't lead to you giving up on investing in the stock market. Understandably, a downturn in the market will tempt you to liquidate assets or exit a position in a volatile company. Still, remember the well-known adage in the investing community: time in the market beats trying to time the market. There's no way of knowing when the best time to sell your stocks is. This is why it's essential to keep a long-term view when investing.

The Bottom Line

Whether a recession causes a stock market drop or the other way around is a question that confuses many people. While it's true that a stock market drop can contribute to a recession, it's more typical for a recession to put downward pressure on stock performance. This is because environmental factors causing a recession and fear of recession can directly influence how people invest.

We've seen in the last year how excess demand and limited supply drove up prices in the United States. The Federal Reserve responded to inflation by instituting a series of rate hikes. These encouraged saving and made borrowing money more expensive. With less money entering the economy, prices and corporate profits dropped.

But a widespread drop in stock prices has not "caused" a recession. Recessions involve various economic factors, not just stock market performance. Both stock market drops and recessions influence each other, but there is no hard rule of one "causing" the other.

The post Does a Recession Cause a Stock Market Drop? appeared first on Due.

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