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Everything You Need to Know About Recessions

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Everything You Need to Know About Recessions

Just like in life, markets go through peaks and valleys. The good news for investors is that often the peaks ascend to far greater heights than the depths of the valleys.

Today’s post helps to put recessions into perspective. It draws information from Capital Group to break down the frequency of economic expansions and recessions in modern U.S. history, while also showing their typical impact.

What is a Recession?

Not all recessions are the same. Some can last long while others are short. Some create lasting effects, while others are quickly forgotten. Some cripple entire economies, while others are much more targeted, impacting specific sectors within the economy.

Recession is when your neighbor loses their job. Depression is when you lose yours.

– Harry Truman

According to the National Bureau of Economic Research, a recession can be described as a significant decline in economic activity over an extended period of time, typically several months.

In the average recession, gross domestic product (GDP) is not the only thing shrinking—incomes, employment, industrial production, and retail sales tend to shrink as well. Economists generally consider two consecutive quarters of declining GDP as a recession.

The general economic model of a recession is that when unemployment rises, consumers are more likely to save than spend. This places pressure on businesses that rely on consumers’ income. As a result, company earnings and stock prices decline, which can fuel a negative cycle of economic decline and negative expectations of returns.

recession expansion cycle

During economic recoveries and expansions, the opposite occurs. Rising employment encourages consumer spending, which bolsters corporate profits and stock market returns.

How Long Do Recessions Last?

Recessions generally do not last very long. According to Capital Group’s analysis of 10 cycles since 1950, the average length of a recession is 11 months, although they have ranged from eight to 18 months over the period of analysis.

Jobs losses and business closures are dramatic in the short term, though equity investments in the stock market have generally fared better. Throughout the history of economics, recessions have been relatively small blips.

Average ExpansionAverage Recession
Months6711
GDP Growth24.3%-1.8%
S&P 500 Returns117%3%
Net Jobs Added12M-1.9M

Over the last 65 years, the U.S. has been in an official recession for less than 15% of all months. In addition, the overall economic impact of most recessions is relatively small. The average expansion increased GDP by 24%, whereas the average recession decreased GDP by less than 2%.

In fact, equity returns can be positive throughout a contraction, since some of the strongest stock rallies have occurred in the later stages of a recession.

Buying the Dip: Recession Indicators

Whether you are an investor or not, it would be wise to pay attention to potential recessions and prepare accordingly.

There are several indicators that people can watch to anticipate a potential recession, which might give them an edge in preparing their portfolios:

Recession IndicatorWhy is it Important?Average Length Until Recession
Inverted Yield CurveOften a sign the U.S. Fed has hiked short-term rates too high or investors are seeking long-term bonds over riskier assets.15.7 months
Corporate ProfitsWhen profits decline, businesses cut investment, employment, and wages.26.2 months
UnemploymentWhen unemployment rises, consumers cut back on spending.6.1 months
Housing StartsWhen the economic outlook is poor, home builders often cut back on housing projects.5.3 months
Leading Economic Index
Aggregation of multiple leading economic indicators. gives a broader look at the U.S. economy.
4.1 months

This is not a magic rubric for anticipating every economic downturn, but it helps individuals see the weather patterns on the horizon. Whether and where the storm hits is another question.

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Markets

Beyond Big Names: The Case for Small- and Mid-Cap Stocks

Small- and mid-cap stocks have historically outperformed large caps. What are the opportunities and risks to consider?

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A line chart showing the historical return performance of small-, mid-, and large-cap stocks.

 

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The following content is sponsored by New York Life Investments
An infographic comparing low-, mid-, and large-cap stocks, including an area graph showing historical returns, a bubble chart showing how much $100 would be worth over 35 years, a horizontal bar graph showing annualized volatility, and a line graph showing relative forward price-to-earnings ratios, that together show that mid-cap stocks present a compelling investment opportunity.

Beyond Big Names: The Case for Small- and Mid-Cap Stocks

Over the last 35 years, small- and mid-cap stocks have outperformed large caps, making them an attractive choice for investors.

According to data from Yahoo Finance, from February 1989 to February 2024, large-cap stocks returned +1,664% versus +2,062% for small caps and +3,176% for mid caps.  

This graphic, sponsored by New York Life Investments, explores their return potential along with the risks to consider.

Higher Historical Returns

If you made a $100 investment in baskets of small-, mid-, and large-cap stocks in February 1989, what would each grouping be worth today?

Small CapsMid CapsLarge Caps
Starting value (February 1989)$100$100$100
Ending value (February 2024)$2,162$3,276$1,764

Source: Yahoo Finance (2024). Small caps, mid caps, and large caps are represented by the S&P 600, S&P 400, and S&P 500 respectively.

Mid caps delivered the strongest performance since 1989, generating 86% more than large caps.

This superior historical track record is likely the result of the unique position mid-cap companies find themselves in. Mid-cap firms have generally successfully navigated early stage growth and are typically well-funded relative to small caps. And yet they are more dynamic and nimble than large-cap companies, allowing them to respond quicker to the market cycle.

Small caps also outperformed over this timeframe. They earned 23% more than large caps. 

Higher Volatility

However, higher historical returns of small- and mid-cap stocks came with increased risk. They both endured greater volatility than large caps. 

Small CapsMid CapsLarge Caps
Total Volatility18.9%17.4%14.8%

Source: Yahoo Finance (2024). Small caps, mid caps, and large caps are represented by the S&P 600, S&P 400, and S&P 500 respectively.

Small-cap companies are typically earlier in their life cycle and tend to have thinner financial cushions to withstand periods of loss relative to large caps. As a result, they are usually the most volatile group followed by mid caps. Large-cap companies, as more mature and established players, exhibit the most stability in their stock prices.

Investing in small caps and mid caps requires a higher risk tolerance to withstand their price swings. For investors with longer time horizons who are capable of enduring higher risk, current market pricing strengthens the case for stocks of smaller companies.

Attractive Valuations

Large-cap stocks have historically high valuations, with their forward price-to-earnings ratio (P/E ratio) trading above their 10-year average, according to analysis conducted by FactSet.

Conversely, the forward P/E ratios of small- and mid-cap stocks seem to be presenting a compelling entry point. 

Small Caps/Large CapsMid Caps/Large Caps
Relative Forward P/E Ratios0.710.75
Discount29%25%

Source: Yardeni Research (2024). Small caps, mid caps, and large caps are represented by the S&P 600, S&P 400, and S&P 500 respectively.

Looking at both groups’ relative forward P/E ratios (small-cap P/E ratio divided by large-cap P/E ratio, and mid-cap P/E ratio divided by large-cap P/E ratio), small and mid caps are trading at their steepest discounts versus large caps since the early 2000s.

Discovering Small- and Mid-Cap Stocks

Growth-oriented investors looking to add equity exposure could consider incorporating small and mid caps into their portfolios.

With superior historical returns and relatively attractive valuations, small- and mid-cap stocks present a compelling opportunity for investors capable of tolerating greater volatility.

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