New Year’s Resolutions for Investors: Recognize “Old News”

Submitted by A Dash of Insight

One of the biggest challenges for the investor is interpreting the constant news flow. One problem is distinguishing fresh news from information that is already widely known. The average investor may read something and act without evaluating what is already reflected in the market.

A Good Example

Suppose our typical investor checked out this article by Mike Panzner on Seeking Alpha. Panzner, writes in typical fashion as follows:

Even if you don’t buy my argument that the far-reaching liquidation pressures associated with the bursting of the biggest credit-bubble in history will ultimately hammer equities along with almost every other asset class, history suggests that a recession — which is growing ever more likely by the day — is bad news for share prices. In “Preparing Stock Players for a Recession,” the New York Sun’s Dan Dorfman reports on what happened during past U.S. downturns.

The Panzner comment is really just an unsupported opinion and a pointer to Dorfman. The rest of the article is an extended quotation from Dorfman who explains the definition of a recession and then cites this scary information:

In an intriguing research exercise, the chief investment strategist of Standard & Poor’s, Sam Stovall, has taken a probing look at what happened to the stock market during the last 11 recessions, dating back to 1945, and offers up some telling disclosures. For starters, recessions, as you might expect, can be devastating to the stock market, with the S&P 500 in one instance — between March and November 2001 — falling more than 49%.

Dorfman admits, in a paragraph not quoted by Panzner, “S&P’s chief economist, David Wyss, thinks that at least one quarter of a decline in real GDP is a possibility, and he has therefore elevated his recession-risk estimate to 40% from 33%.”

He does not mention the lower recession odds of many other economists, or that there is always, on average, a 20% chance of a recession. It is all scare, good for selling papers.

But what about the Sam Stovall research? What should we make of this? The first thing to note is that the research was widely-disseminated in the mass market TIME magazine with the cover date of November 28th. When it is published in TIME, it is far from being fresh news. In fact, market analysts and major market players have been discounting future earnings for months. Dorfman is slow on this and Panzner is slower.

Content of the Stovall Research

It would be helpful to take an independent look at the Stovall research, but no one provides a reference. All we know is that he went back 60 years and considered ten recessions.

There are several problems with this type of recession analysis:

Most importantly, bearish pundits point to 2001 as a worst case. That recession was actually rather mild. The stock market decline came from over-valuation, but is often falsely attributed to the recession. Market valuations now are far different from the 2001.

An Alternative Viewpoint

Bespoke Investment has published a wonderful document, providing plenty of insight on important questions facing investors in 2008. (Check out their site to subscribe for this valuable report). In the section on recessions and effects, they write as follows:

While we would assume that an economic recession would be negative for stocks, given
the market’s discounting mechanism, the S&P 500 and most of its sectors typically have positive returns during actual recessions. However, most of the gains come towards the back half of the contraction.

Conclusion

The Bespoke Report contains plenty of data and provides a nuanced view of recessions. A thoughtful reader will realize that the market effect is not a simple one. A lot has to do with how much of the impact is already reflected in market prices.

Assessing market impact of a recession is not as simple as cursory reading may suggest. One needs to figure out the recession probability, the likely effect, and what is built into the current market prices. These are all topics extensively treated at “A Dash” in our recession series.

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