FROM its peak on Oct 9, 2007, the US Standard & Poor's 500 Index has fallen about 15 per cent. But does this point to an economic recession?
The market, as measured by the performance of the S&P 500, has foretold each of the 10 recessions in the US since World War II.
Where we stand today, is it 100 per cent certain the US will go into recession soon? And if so, how much will stocks slide?
The accompanying chart shows the S&P 500 index from January 1947 to December 2003. The shaded areas represent periods of recession as defined by the US National Bureau of Economic Research.
As can be seen from the chart, every recession has been associated with a fall in the S&P 500. And nine out of the 10 times - the exception was 1980 - stock prices fell ahead of the recession.
Table 1 summarises details from the chart. It shows whether the stock market fell before the start of a recession and started to rise before the end of a recession.
Finance scholar Siegel defines a fall before a recession as a decline of 8 per cent or more. A peak is the highest level from which prices fall 8 per cent. A trough - the low point of the index - is defined as the lowest level before stock prices rise 8 per cent.
From Table 1 you can see that stock prices peaked anywhere from zero to 13 months before the start of a recession.
The average lead-time between the peak of the S&P 500 and the start of a recession was 6.3 months. The average stockmarket decline before a recession was 9.9 per cent.
The average decline in the market before and during a recession was 21.7 per cent. But the range is wide, from a none too shocking 10.6 per cent in 1953-54 to a collapse of 46.2 per cent in 1973-75.
On average, these declines happened over 12 months.
According to a report by the Federal Reserve Bank of Atlanta, the market typically falls less before a recession than during one. "The stock market does not necessarily decline substantially before a recession," the bank said. "But the onset of a recession is invariably associated with a substantial decline in stock prices."
In each of the 10 US recessions since World War II, prices began to rise before the recession ended. On average they started to move up 5.7 months before the economy rebounded.
S&P 500 falls
It must be pointed out, however, that although all recessions have been preceded by declines in stock prices, not all declines in stock prices have been followed by a recession.
For example, between December 2001 and September 2002, the S&P 500 shed 29 per cent. It rebounded 14.9 per cent from September to November 2002, then fell again by 10.2 per cent from November 2002 to February 2003.
There was no recession within 12 months of the start of the 2002-03 decline in stock prices.
In fact, the revised estimate of GDP growth for the third quarter of 2003 was in excess of 8 per cent - more than a little distance from recession.
Table 2 shows the other times since World War II when stock prices fell 8 per cent or more but no recession began within 12 months.
In all, the S&P 500 has fallen 8 per cent or more on 19 occasions since 1945. Recession occurred only 10 of those times.
In other words, recessions have occurred 53 per cent of the times that falling stock prices would suggest a recession. So falling prices are roughly a 50-50 predictor of recession.
Put another way, if stock prices drop 8 per cent or more it means there is about a 50 per cent chance of a recession. And the magnitude of the decline has no bearing on whether a recession will follow. As mentioned, between December 2001 and September 2002, the S&P 500 fell a sharp 29 per cent but there was no recession.
Black Monday
Between June and August 1998 - the throes of the Asian financial crisis and the Russian debt default - the index was down 15.6 per cent. And in 1987 - the infamous Black Monday - the S&P 500 plunged 30.2 per cent. Again there was no recession.
Admittedly, the data we are getting out of the US now is not that sanguine. Some reckon the world's biggest economy is already in recession.
If that is the case, based on the previous 10 recessions, the maximum decline in the stock index will be between 10.6 and 46.2 per cent.
And if a portfolio is made up of small cap stocks, chances are it will decline even more.
I've decided to look at the characteristics of bull and bear markets in Singapore by measuring the performance of the Straits Times Index (STI).
From 1973 until 2007 we had eight bear and bull markets. From Table 3, you can see the bear markets tended to be shorter. The average bear market lasted about 18 months and the median was 15.2 months. Actually, the longest down-market we've seen was between December 1999 and March 2003 - and that's 38 months.
As for bull markets, they averaged 32 months, with the median about two years. The longest sustained uptrend for the STI was between March 2002 and October 2007.
Price declines, although shorter in duration, also tended to be sharper than price increases. The median annualised decline was 41.2 per cent. This compared with the median appreciation of 33.3 per cent.
The average annualised increase in stock prices during a bull market was pulled up by three significantly good periods - in the eight-and-half months from August 1982, the 21 months after the Christmas of 1985, and the 16 months from September 1998 after the Asian financial crisis.
In the past two months or so, the STI has lost some 20 per cent. Many small caps have lost considerably more.
If you have not pared your holdings, it is probably too late to do so now. But it appears to me that the selling has been rather ferocious and there is, in fact, value emerging in the market right now.
The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg
