U.S. economic recessions are contractions in growth identified by the Business Cycle Dating Committee of the National Bureau of Economic Research, usually well after the fact. Arthur Okun, an economic advisor to Presidents Kennedy and Johnson, developed the rule of thumb in which two successive quarters of real GDP decline signals a recession. It’s only a guide, however, as the recessions of 1981 and 2001 occurred with only one quarter of GDP decline. Since 1945, there have been 11 recessions occurring every 5.5 years, on average. The longest stretch between recessions was the 128 months separating the 1990 and 2001 recessions. The shortest was in the early 1980s, with only 18 months between them; some economists say those two were just one long recession separated by a short spate of growth. On average, recessions have lasted a little more than 10 months. Six stuck around 10 months or more, with the two longest occurring in the 1970s and ‘80s.

Stock Market Performances in Anticipation of and During U.S. Economic Recessions

Since the intrinsic value of equities is based largely on the underlying growth in corporate earnings, it should come as no surprise that equity investors have historically anticipated the onset of economic slowdowns or contractions. Every recession since World War II was preceded by declines in equity prices that eventually became a bear market seven times (a decline of 20% or more), a contraction three times (declines of 10%-20%) and a pullback only once (a 5%-10% decline). In all, the average sell off in equity prices before and during recessions saw a decline of 26% in value for the S&P 500. In addition, more speculative benchmarks, such as the Nasdaq and Russell 2000 index of small companies, also posted price declines ahead of recessions – usually in excess of the declines recorded by the larger-cap issues. Due to the U.S.’s global influence, the decline in U.S. equity prices during these periods may also have largely influenced the MSCI-EAFE’s (a benchmark of global large-companies in developed nations) average decline of 23%. Therefore, the reason investors have such an overwhelming fear of recessions, in our opinion, is the magnitude and frequencies of declines associated with these economic weak spots. What’s more, investors have come to learn that during recessions, there are few places to hide.

Price Performances Before/During Recessions 1945-2002

	Old Inds. (8 Obs.)			New Inds. (2 Obs.)			Weighted
Date	Average	Outperf.		Average	Outperf.		Average	Outperf.
All Industries/S&P 500	(18.8)	NA		(30.6)	NA		(21.2)	NA
Consumer Staples	(6.0)	88%		12.3	100%		(2.4)	90%
Utilities	(13.5)	88%		(21.1)	100%		(15.0)	90%
Health Care	(8.1)	75%		(3.8)	100%		(7.3)	80%
Financial	(13.6)	88%		(26.5)	50%		(16.1)	80%
Information Technology	(10.6)	63%		(53.6)	0%		(19.2)	50%
Energy	(22.8)	25%		(8.4)	100%		(20.0)	40%
Consumer Discretionary	(22.0)	38%		(32.1)	50%		(24.0)	40%
Materials	(21.2)	13%		(19.3)	50%		(20.8)	20%
Industrials	(29.1)	0%		(28.2)	50%		(28.9)	10%
Telecommunications Services	NA	NA		(41.7)	50%		(41.7)	NA
Tobacco	0.2	100%		47.2	100%		9.6	100%
Household Products (Non-Durables)	(2.1)	100%		17.3	100%		1.8	100%
Foods	(7.1)	88%		17.0	100%		(2.3)	90%
Health Care (Drugs - Major Pharmaceuticals)	(8.6)	88%		(7.1)	100%		(8.3)	90%
Insurance (Property-Casualty)	(12.5)	100%		1.9	50%		(9.6)	90%
Banks (Money Center)	(11.0)	100%		(22.2)	50%		(13.2)	90%
Beverages (Alcoholic)	(0.4)	75%		31.4	100%		6.0	80%
Beverages (Non-Alcoholic)	(9.1)	75%		5.3	100%		(6.2)	80%
Retail (Food Chains)	(6.9)	88%		(25.4)	50%		(10.6)	80%
Electric Companies	(9.1)	63%		(4.9)	100%		(8.2)	70%
Footwear	(17.6)	75%		(1.6)	50%		(14.4)	70%
Retail (Department Stores)	(14.8)	75%		(18.5)	50%		(15.6)	70%
Oil (International Integrated)	(21.9)	63%		(6.0)	100%		(18.7)	70%
Insurance (Life & Health)	(13.4)	63%		(15.7)	50%		(13.9)	60%
Containers (Metal & Glass)	(18.8)	50%		(7.2)	100%		(16.5)	60%
Natural Gas	(17.9)	63%		(25.2)	50%		(19.3)	60%
Gold & Precious Metals Mining	(5.7)	38%		(4.1)	100%		(5.4)	50%
Publishing	(21.0)	50%		(9.9)	50%		(18.8)	50%
Computers (Hardware)	(12.4)	63%		(45.2)	0%		(19.0)	50%
Entertainment	(17.4)	63%		(45.5)	0%		(23.0)	50%
Household Furnishings & Appliances	(19.6)	38%		(18.6)	50%		(19.4)	40%
Paper & Forest Products	(20.9)	38%		(17.2)	50%		(20.2)	40%
Chemicals	(21.1)	38%		(22.6)	50%		(21.4)	40%
Aerospace/Defense	(28.4)	25%		(4.7)	100%		(23.7)	40%
Electrical Equipment	(21.5)	50%		(35.6)	0%		(24.4)	40%
Metals Mining	(25.1)	38%		(23.3)	50%		(24.7)	40%
Machinery (Diversified)	(27.3)	38%		(19.0)	50%		(25.6)	40%
Containers & Packaging (Paper)	(26.0)	25%		(36.0)	50%		(28.0)	30%
Aluminum	(30.0)	25%		(28.5)	50%		(29.7)	30%
Trucks & Parts	(35.8)	25%		(22.8)	50%		(33.2)	30%
Railroads	(30.6)	13%		4.9	50%		(23.5)	20%
Iron & Steel	(22.5)	13%		(28.0)	50%		(23.6)	20%
Oil & Gas (Drilling & Equipment)	(25.5)	13%		(29.4)	50%		(26.3)	20%
Automobiles	(25.8)	25%		(46.5)	0%		(29.9)	20%
Building Materials	(27.5)	0%		(28.1)	50%		(27.6)	10%
Airlines	(35.1)	13%		(40.7)	0%		(36.2)	10%
Source: Standard & Poor's Equity Research Past performance is no guarantee of future results

Rotations and Recessions
An old saying states “There is always a bull market someplace” – either in individual sectors or industries. Does this adage hold true during recessionary periods? Yes, but not for many. S&P introduced its Global Industry Classification System (GICS) in 1994, globally categorizing companies into a consistent number of sub-industries at the detailed level and sectors at the summarized level since 1990. Prior to 1990, only sub-industry (then called industry) level-data was available. To see how sectors and sub-industries fared during the equity market declines identified on page one, I computed the price performances for the pre-1990 industries during the eight recessionary periods since 1945 (I had to exclude the 1944 observations for lack of data) and averaged their performances up to the sector level. After 1990, the sub-industry and sector performances were computed using available indices. I then computed a weighted performance value and frequency of market outperformance for all 10 sectors in the S&P 500 and 36 sub-industries that participated in all 10 periods observed. As with all historical comparisons, please bear in mind that what happened in the past may no longer hold true for the future.

On a sector level, I found that there was no place to hide – on average, all 10 sectors in the S&P 500 posted a decline. During all observations, the overall benchmark fell an average 21%, using month-end data based on the average industry (prior to 1990) or the S&P 500 (post-1990). Understandably, the smallest declines were recorded by the traditionally defensive sectors (called “defensive” because they usually fell less than the overall market) of Consumer Staples (down 2.4% but beat the overall market 90% of the time), Health Care (average decline of 7.3% and frequency of outperformance at 80%) and Utilities (with an average decline of 15% and a 90% F.O.). Interestingly, Financials also held up relatively well, falling an average 16% and beating the market 80% of the time. The worst performers were Industrials (which declined an average 29% and beat the market only 10% of the time), Materials (which were off an average 21% and a 20% frequency of outperformance) followed by Consumer Discretionary (-24% decline/40% F.O.) and Energy (-20%/40%).

On a sub-industry level, only three groups posted positive returns over the 10 periods: 1) Tobacco, up an average 9.6% and a 100% frequency of outperformance; 2) Household Products, up 1.8% on average and another perfect F.O. score; and 3) Beverages (Alcoholic), which gained an average 6.0%, and beat the market 80% of the time. Honorable mention goes to three more groups: 1) Foods (now called Packaged Foods & Meats), which fell an average 2.3% but posted a 90% frequency of outperformance; 2) Pharmaceuticals, which fell an average 8.3% with a posted F.O. of 90%; and 3) Beverages (Non-Alcoholic), now called Soft Drinks, which declined 6.2% and recorded an F.O. of 80%. Interestingly, while Gold declined an average 5.4%, it only beat the market 50% of the time.

Does Today’s Posturing Point to a Further Pullback?
Many investors tell me they strive to understand where we are in the economic cycle in order to decide which sectors to invest in. My initial response was that if the stock market anticipates the economy by nearly nine months, wouldn’t one want to observe sector rotation in order to see if we are headed for an economic downturn? To paraphrase a Top-40 song of 1963, that’s “easier said than done.” I have found that whenever the market appears to be undergoing a decline – be it on the order of noise (0%-5%), a pullback (5%-10%), correction (10%-20%) or a bear market (20%+) --  sector rotation since the start of the decline frequently occurs with defensives on top and cyclicals on the bottom. Unfortunately for strategists with an intermediate-term time horizon (six to 12 months), while there have been 11 recessions since 1945, there have been 49 pullbacks, 16 corrections and 10 bear markets. Therefore, 64 of these 75 market sell offs incorrectly anticipated the 11 eventual recessions. What’s more, these alignments usually didn’t last very long, as I demonstrated in my article “Using History as Virtual Valium.” Pullbacks typically recovered in about two months, while corrections righted themselves in fewer than four months. So it is imperative that we are confident of a recession before we call for defensive posturing. And right now we don’t.

A Charmin Economy: Softness Ahead
If one merely looked at the average time between recessions (now six years since the last one), they could conclude that another recession is due. S&P’s Chief Economist, David Wyss, Ph.D., disagrees. With apologies to Mr. Whipple, S&P sees economic softness ahead, but not the squeeze of recession. We forecast that U.S. real GDP growth will decline from the 3.9% pace recorded in the third quarter of 2007 to a 0.6% growth rate in Q1 2008, book-ended by a more-favorable 1.4% growth in Q4 ’07 and a 1.5% advance in Q2 ‘08. Wyss admits that we may come perilously close to at least one quarter of real GDP decline, and has therefore elevated his risk of recession to 40% from 33%. He sees consumer growth slowing in 2008, but not evaporating as result of a continued strength in employment. And while domestic demand may be slowing, Wyss sees exports rising 10% in 2008, following the near 8% advance in 2007, and serving as an offsetting source of growth.

Oil prices remain the swing factor in our opinion. S&P recently raised its oil price forecast to an average $84.67/barrel for 2008. Wyss recently wrote, “Most analysts believe the current run-up was caused by the geopolitics, and the balance of supply and demand suggests a lower price. However, we have been saying that for awhile, and prices keep going up.” S&P therefore thinks higher oil prices are more the result of strong global demand, rather than a rising risk of supply disruption. This distinction is important, in our opinion. Wyss reasons that when demand pulls oil prices, the higher costs to the oil importers are balanced by higher income for oil exporters, who either spend the money or invest it. This recycling of petroleum revenues should help keep the world economy going despite higher costs.

We also believe a proactive Federal Reserve will help the U.S. avoid recession. The Fed has cut the Discount rate three times and the Fed funds rate twice. We think the Fed’s recent statement was tough, but S&P Economics expects the weakness in the economy to force another rate cut, most likely in January. The Fed is right to be concerned about inflation, in our view, especially given the falling dollar and its impact on consumer prices. But in the short run, we see recession as the bigger risk.

Technically Speaking: Down But Not Out
Mark Arbeter, S&P’s Chief Technical Strategist, agrees that recent market action has been ugly, but he’s not convinced that a bear market is at hand. For him, the August lows still hold the key. If they are broken, however, he thinks the long-term charts will be warning of a bear market ahead. For now, however, Arbeter reminds us that the August lows are still holding for the S&P 500 and Nasdaq, and states that the Dow’s break of its closing low was very minor. Other indicators also indicate to him that this is likely to be an 8%-12% decline from recent highs, and not the start of a new bear market. In particular, he has not seen bearish “crossovers” of exponential moving averages (EMAs) -- the 17 week and 43 week comparison is his favorite. He also notes that trendlines and Relative Strength Indicators (RSIs) also remain in bullish territory. Market internals also appear washed out, which indicate to him that a bottom is near. Finally, he points to investor sentiment being extremely bearish, which, when used as a contrary indicator, has been historically indicative of intermediate term bottoms. But like all historical look-backs, past performance is no guarantee of future results.

Sticking With Our Weightings
S&P’s Equity Strategy Group is maintaining its non-recessionary investment stance, but acknowledges that an inflection point may be near. We currently recommend overweighting the Information Technology sector, while underweighting Consumer Discretionary and Financials. Should the S&P 500 ultimately signal an approaching bear market, however, we still believe the repositioning of sector emphasis will be worthwhile. Even though the market may have surrendered up to 12% of its value before the signal was given, we are reminded that average recession-related bear markets have given back 26% of the market’s value. A correctly timed call, therefore, could occur with more than 50% of the overall decline yet to come. You’ll just have to stay tuned.