January 10, 2008

With the stock market down more than 10% from its recent highs and evidence mounting that the U.S. economy is losing momentum, many investors are concerned about the possibility of a recession in 2008. Indeed, some analysts are already predicting poor stock returns for this year, particularly if inflation and unemployment continue to rise in tandem.

"Whether a recession will occur in the U.S.—or is already under way—remains to be seen," said Joseph Davis, Ph.D., a principal and economist for Vanguard's Investment Counseling & Research (IC&R) and Fixed Income Groups. "Recessionary periods are notoriously difficult to predict. For instance, the most recent recession ended in November 2001, which was precisely the month that the National Bureau of Economic Research first announced that a recession had begun that March."

"It's evident, however, that some economic and financial data are pointing toward a near-term contraction in activity," Mr. Davis said. "While the stock market crash of 1987 didn't lead to an economic recession, stock markets have historically tended to decline before the onset of an economic recession in anticipation of declines in corporate profits."

How should investors respond?

Source: National Bureau of Economic Research. S&P 500 Index shown on a logarithmic scale for clarity.

"Without question, the severity of any recession matters," Mr. Davis said, "but long-term investors who looked at the big picture and bore stock market risk during periods of economic uncertainty were ultimately rewarded for their patience."

Past is prologue, but it's not a crystal ball

Of course, history isn't a guarantee of future performance, and past recessions can't predict future stock returns. Indeed, the S&P 500 Index posted positive returns during five of the last nine recessions. As the table below indicates, there's no clear historical pattern.

Recession	Nominal S&P 500 Return	Real S&P 500 Return*
July 1953–May 1954	23.63%	23.10%
August 1957–April 1958	–1.31%	–3.64%
April 1960–February 1961	20.04%	19.02%
December 1969–November 1970	–1.92%	–6.96%
November 1973–March 1975	–7.79%	–22.82%
January–July 1980	9.53%	3.64%
July 1981–November 1982	14.22%	7.11%
July 1990–March 1991	7.89%	4.59%
March–November 2001	–0.90%	–1.70%

* Adjusted for inflation using the Consumer Price Index. Data sources: Vanguard and the National Bureau of Economic Research. While business commentary typically defines a recession as two consecutive quarters of negative real growth in gross domestic product, the National Bureau of Economic Research (NBER) is the recognized arbiter of U.S. recession dates. The NBER has identified nine recessions in the U.S. since 1953, with an average duration of 11 months.

Just as recession hasn't always heralded a bear market for stocks, periods of economic growth haven't always been accompanied by major gains on Wall Street. Vanguard IC&R research has found that the average monthly return on the S&P 500 has been higher during economic expansions than during recessions (1.05% versus 0.76%), but the difference is not statistically significant—"statistical noise," Mr. Davis suggested. Perhaps less surprising, stock market volatility has been significantly higher during recessions, as risk premiums rise during periods of economic uncertainty.

"The primary reason there hasn't been a strong relationship between recessions and stock market returns comes down to timing," Mr. Davis said. "It's inherently difficult for equity investors to 'time the economy' by getting out of—or back into—the stock market at just the right moment."