Why investors should beware the myth of a friendly recession

Open this photo in gallery:

Beware the myth of the friendly recession.

Judging from the market’s behaviour this week, many people seem to be betting on the notion that the economy is headed into a mild downturn that will cool inflation and tame oil prices without doing much damage to corporate earnings or stock prices.

In theory, this is possible. In practice, though, it would be unusual to experience such a well-behaved pullback.

Consider the downturn of 2001. The U.S. economy entered a brief, shallow recession after the collapse of the dotcom bubble and the 9/11 attacks on the World Trade Center and the Pentagon. Canada’s economy slowed but never slid into recession.

So did this also mean a brief, mild setback for stocks? Not at all. In the U.S., the S&P 500 index lost 12 per cent in 2001 and another 22 per cent in 2002, while in Canada stocks slid 13 per cent in 2001 and another 12 per cent in 2002.

In short, the stock market pain was neither mild nor brief despite a shallow, short-lived U.S. recession.

The 2001 experience illustrates a broader point: There is no historical correlation between the magnitude of recessions and the extent and duration of corresponding bear markets in stocks, according to David Rosenberg of Rosenberg Research.

The lack of correlation makes sense if you step back and consider how variable stock valuations can be. Some recessions (like the 1980-to-1982 downturn) commence when stocks are trading at relatively low multiples of their earnings. In these cases, stocks are cheap and don’t have that far to fall before their bargain appeal begins to attract buyers.

Other recessions (like the one in 2001) start when stocks are still trading at frothy multiples. In such cases stocks are expensive. They have to endure painful declines before investors are again willing to gamble on them.

The current situation is more similar to the 2001 case. Compared with their earnings history over the past decade, both U.S. and Canadian stocks still look pricey. They appear modestly valued only if you accept increasingly upbeat predictions of how much companies will earn over the year ahead.

Just how upbeat are these estimates? In early January – before Russia invaded Ukraine and before central banks started talking tough on interest rates – analysts were forecasting that U.S. and Canadian companies would increase their earnings per share by about 8 per cent in 2022, according to Citigroup.

Despite all the bad news since January, analysts have grown steadily more optimistic. They now expect U.S. companies to increase their earnings almost 9 per cent over the coming year and see Canadian companies boosting their profits by a sizzling 22 per cent. In both countries, earnings estimates are moving higher primarily because of rising expectations of how much oil and gas producers will make over the coming year.

Maybe these optimistic estimates will pan out. Still, it is rather odd to be counting on higher corporate profits while people are fretting about a possible recession ahead.

The contrast between darkening economic numbers and increasingly sunny forecasts for earnings breeds uncertainty among investors. It results in days like Tuesday, when stocks plunged in the morning on recession fears only to recover all their losses in the afternoon and finish with a gain.

The simplest way to explain this abrupt turnaround is to assume that some investors are assuming a benign downturn. Their theory may be that a slowing economy will reduce demand for energy. This will bring down oil and gas prices, which will lower inflation, which will give central banks a reason to take it easier when it comes to hiking interest rates. If things work out just right, any economic slowdown could be relatively mild.

This theory is not entirely wacky. Oil prices have tumbled in recent days as recession fears have grown.

Inflation fears have also been receding. Back in late March, the bond market was braced for U.S. inflation to average 3.6 per cent a year over the next five years. Now it foresees annual average inflation of just over 2.5 per cent between now and 2027.

It’s not clear, though, why any of this should necessarily be a reason to buy stocks now. Yes, the economic slowdown ahead may be milder than once feared. But history shows that even a brief, mild stumble in growth could hurt, especially when valuations in many sectors are still as elevated as they are now.

Investors should be wary. The slowdown ahead doesn’t have to be big to inflict serious pain.

Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.