Lessons from the past

Nov 5 2008 by Andrew Miller, The Journal

OCTOBER was a grim month for equities, with levels of volatility not seen since 1987 and, prior to that, 1932. The turmoil was driven in part by fears of recession and, in some cases, talk of depression – although we believe that policymakers around the world have done enough to avoid the latter scenario.

Of course, the potential hit to earnings, cash flows and dividends that a recession would bring is negative for equity markets. But this neglects the fact that equities are a forward-looking asset class and should move in a cycle that leads the underlying economy, rather than in one that follows behind.

Last year, we looked at the linkage between the economy and equities, and examined how markets performed through previous recessions. We have now updated this work to reflect our current position in the economic cycle. Reliable data for equity returns, in particular for sectors, does not extend back much before the 1960s, so we have focused our analysis on the recessions since then. Furthermore, a long time series of recession data for the euro area does not exist, so the main focus of our analysis is on the US. However, we have also included some analysis on the UK.

Looking at the performance of the S&P 500 index in the two years leading up to and following the start of a recession, it is clear that on only two occasions in the last eight recessions has the US equity market been at a lower level two years after the start of a recession than at the beginning. In fact, only on three occasions has the equity market been below the starting level one year later. This suggests that it is more likely than not that equity markets will be higher one and two years after a recession – significantly so in some cases.

One other trend is also apparent. Again, the appropriate indices do not cover the whole period, but are long enough to cover the last four US recessions and the last two UK recessions. In the three most recent US recessions (1981, 1990, and 2001), value stocks (typically stocks with low price-to-earnings ratios and higher than average dividend yields) outperformed leading up to the recessions, and growth stocks (stocks that are expected to deliver strong growth in earnings) outperformed in the period after. In the UK recessions of 1979 and 1990, value outperformed in the run-up to the recession, while growth stocks outperformed thereafter.

So, it seems that value stocks outperform in anticipation of a recession as investors scramble to the relative safety provided by them. Once the recession arrives, however, investors begin to turn their attention to the forward growth prospects for stocks.

At the moment, we’d stress that a large-company, value bias makes most sense for equity investors and we still prefer attractively valued companies with healthy balance sheets and well covered dividends. But, as the downturn progresses, it’s worth remembering that investors will start to look to the future again one day – even though that may just seem like wishful thinking at the moment.

Andrew Miller is regional office head of Barclays Wealth