Are We in a Recession? (and What Should You Do About It?)

On April 2, 2008, Federal Reserve Chairman Ben Bernanke finally conceded that the U.S. economy may be slipping into a recession. Of course, that’s hardly news to most Americans for whom it has felt like a recession since the latter part of 2007.

A recession is usually defined as two or more consecutive quarters of declining gross domestic product (GDP), but this is an oversimplification. The official arbiter of recessions is the National Bureau of Economic Research (NBER), which defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months. The NBER analyzes a variety of economic indicators such as inflation-adjusted GDP, income levels, employment, industrial production, and personal consumption. Based on this analysis, they determine whether a recession has in fact occurred.

Although the NBER has not yet made it official, most economists believe that we are now in a recession. But will it be severe? And how long will it last? Here expert views are divergent. Harvard economist Martin Feldstein, who serves as president of the NBER, is concerned that a weak housing market, illiquid credit markets, and rising inflation and unemployment will lead to a severe recession lasting well into 2009. Other economists, such as Brett Hammond at TIAA-CREF, predict a brief and shallow economic downturn. As for Mr. Bernanke, he expects things to turn around in the second half of the year as lower interest rates and the government’s stimulus package invigorate the economy.

What does this mean for investors? The stock market tends to anticipate economic developments. Stock prices typically begin declining several months before the onset of a recession, hitting bottom about six months before the recession is over. Stocks usually rally during the latter part of a recession, recouping their losses in an average of eight months.

Then why not move money out of stocks at the beginning of a recession and reinvest when the economy begins to improve? Unfortunately recessions are not that predictable. The NBER typically does not specify the beginning and ending dates of a recession until a year or so after those dates have occurred. Considering that the average recession lasts only 11 months, the retrospective labeling of an economic downturn does not help investors. In real time, even the best economists can’t agree on when a recession has started or how long it will last.

The important thing for investors is to stay disciplined and avoid any rash moves. When investors panic, they typically move their money from assets that have recently performed poorly into assets that have recently done well. An example at this point in time would be selling stocks and buying gold. The problem with this strategy is that it is difficult to get the timing right. The last thing you want as an investor is to sell low and buy high.

Is there anything that you should do differently during a recession? That depends on your financial circumstances. If you are saving for retirement, it is important to keep investing. A falling stock market presents an opportunity to buy additional shares at a reduced price. If the economic downturn has affected your daily cash flow, it may be necessary to cut down on discretionary expenses. If you are a retiree (with less time to recover from a drop in the stock market), it may be prudent to reduce your portfolio withdrawal rate to preserve your long-term purchasing power.

The economy has always been cyclical in nature. There have been eight recessions over the past 50 years. And yet, an investor who remained fully invested in the U.S. stock market during this time period would have realized an average annual return of 10.9%. Market volatility is unavoidable fact of life for the long-term investor. One of the keys to successful investing is to have a sound asset allocation strategy in place and to stick with it in times of economic turmoil.

Please do not hesitate to contact me if you have any questions or comments.

Jeffrey J. Brown, MD MBA CFA

Principal, Shearwater Capital