FINANCIAL TOOL
Recession vs Bear Market
We’ve been hearing the word “recession” tossed around a lot lately.
For the stock market, what matters is whether a bear market is on the horizon.
A recession is roughly defined by two consecutive quarters of negative economic growth (measured by GDP). The National Bureau of Economic Research has the final word on this, as they also consider other factors such as unemployment, personal income, etc.
A bear market is defined by at least a 20% drop in the stock market from its most recent high point.
More often than not, a bear market has happened in close proximity to a recession, sometimes starting before and sometimes after the onset of the recession.
Depending on the timeline observed, historically about 75% of bear markets have happened in connection with a recession around the same time.
What can we learn from this? If a bear market occurs, there’s a decently high chance that we’re already in a recession or are quickly approaching one.
But if we’re going to save our investments from the worst effects of a bear market, we can’t afford to wait for the 20% drop to happen!
Because once we learn we’re in a recession, it’s usually far too late to avoid the bear market. Collectively, investors tend to predict recessions with stock market values before they’re ever recognized to be in effect.
It’s not necessary to be 100% correct when predicting a bear market, however.
What’s important is to recognize the conditions in which they usually form, and then reduce risk more or less according to what red flags are arising.
So long as you can keep upside potential strong (by holding onto equities), you can place hedges with protective put options to keep downside from being catastrophic to your plan.
In times when red flags are prominent, a put option with a strike price closer to the current price (think 5% below) might be a smart choice. When there are more green flags than red flags, keeping the strike price further (think 10 to 15% below the current price) can be a cheaper move that creates less of a drag on the portfolio.
Without listing all the red flags of a bear market, here’s one worth noting.
Too much unity in the political environment.
When the US President and the Congress feature the same party in power, if the party is unified, this can create a scenario where legislation happens very quickly. This rapid and sometimes dramatic change to law can cause businesses and consumers to pause or slow their otherwise normal spending and investing activities.
The downside potential this creates isn’t necessarily because the changes being made are good or bad.
It’s more due to the impact of Prospect Theory:
1.) The opposing party feels fear, anger and distrust. And negative emotion, the pain of perceived loss, is felt 2.5x more than the equivalent feeling of gain. This can drive the market in a negative direction.
2.) Changing rules often create winners and losers. For the same reasons, the feeling of loss overpowers the feeling of gain and drives markets downward.
This isn’t a hard and fast rule, but it is a reason why bear markets and corrections so often happen during the first half of a US President’s term (regardless of political party in power). In mid-term elections, the President’s party usually loses seats in the Congress, creating gridlock that slows the rate of change for the second half of the Presidency.
We’re certainly in a situation right now where things are changing very quickly and dramatically. And the situation is such that uncertainty could just as easily increase as it could decrease from here.
The scope of what is trying to be accomplished, however, is likely something that will take years to fully accomplish. And uncertainty for that amount of time could easily lead to a bear market, and even (though less likely) a recession, in the interim.