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As I talk to investors and practitioners around the world, one question seems to dominate the discussion: Are we heading for a recession?

The U.S-China trade war, Brexit uncertainty, slowing global growth – particularly in China and Europe – a flat yield curve and tightening financial conditions in the face of overleveraged consumer and corporate sectors have spooked economists and market participants in recent months.

What I tell investors is that it all depends on how a well-known seasonal effect in the financial markets will turn out. This effect relates to the adage “sell in May and go away," which argues that stock markets do better in the November-to-April period than in the May-to-October period. This semi-annual seasonality in stock returns has had great success in forecasting recessions in the past.

My research shows that stocks have experienced a positive return in the November-to-April period in 51 of the 61 years of my sample (1957-2017) and a negative return in only 10 years. Of the 10 negative-return years, eight years – 1960, 1970, 1973, 1974, 1982, 1990, 2000 and 2008 – were recession years. That is, the November-to-April period has been dominated by positive stock returns, except during recessions when returns turn negative. By way of comparison, stock returns in the May-to-October period were negative in 25 of the 61 years and only three of these years were recession years. The data come from the Canadian Financial Markets Research Centre (CFMRC) database at the University of Western Ontario and the index used in the calculations is the Equally Weighted CFMRC Index.

The bottom line is this: Strength in stock returns in the period we’re in now – November to April – is observed when there is no recession or bear market in the year ahead. In recessions or bear markets, no such semi-annual stock-return seasonality is generally documented.

At the outset of 2019, this metric was signalling a high probability of a recession in 2019 as the small-cap Russell 2000 was down 12 per cent since the end of October, while the S&P/TSX Completion Index (composed of constituents of the S&P/TSX Composite Index that are not included in the S&P/TSX 60 Index) was down about 8.5 per cent over the same period. Developments since then, however, have reduced significantly the probability of a recession. There has been some optimism regarding a resolution of the U.S.-China trade war and less hawkish comments on interest rates by U.S. Fed chairman Jerome Powell. As of Friday, Russell 2000 is down about 1.7 per cent since the end of October, while the S&P/TSX Completion Index is down 1.5 per cent over the same period.

Another encouraging sign for the markets is evidence that when January is negative there is a high probability that the year will turn out negative, whereas when it is positive the market rises for the year. The CFMRC data referred to above show that the average annual return of the Equally Weighted CFMRC Index is minus 1 per cent when January is negative, but 19 per cent when January is a positive month. In other words, a positive January is a good harbinger for returns in the year ahead. Both the Russell 2000 and the S&P/TSX Completion Index are up significantly so far in January, 10.2 per cent and 6.9 per cent, respectively.

If the stock market recovery continues, especially over the next three months, we will have avoided a recession. On the other hand, if stock market volatility and weakness resume, there will be no need to wait for the economic numbers to confirm that we will be in a recession. Financial markets will have already cast their votes. Stay tuned!

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario

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