As the saying goes, it’s always darkest before the dawn, and right now, it’s feeling pretty dark. There is a lot of bad news floating around. We’ve got the highest rates of inflation we’ve seen since 1982, wages that have stagnated for years and stock markets which have crashed hard from the heady heights of 2021.
Not to mention a political situation that appears to get more ridiculous by the day and the prospect of rising interest rates, which dramatically increase the cost of mortgages and other forms of debt.
Even the bond markets have been rocky, and they’re usually much less volatile due to being backed by the security of global governments. However, rising interest rates have caused prices to fall more than they have almost ever before.
All in all, there appears to be a lot of instability in the financial system, and investors are understandably a bit nervous.
The truth is, this is nothing new.
Many times throughout history there have been recessions and crashes that looked like they could topple the financial system. They all have differences, but they have a lot of similarities too.
We’re going to show you how the stock market and the economy overall interact, and we’ll go over some of the recessions that have happened in the past. We’ll also look at how investors who managed to stick it out were rewarded in the subsequent years.
Let’s stress that this doesn’t mean that’s how things are going to play out now, but it can provide some insight on the possible outcomes we might see.
Before we dive into that we need to understand the premise of the stock market. We’re going super high level here. Everyone knows what the stock market is. It’s where you can buy shares in companies. The stock prices can go up and down, with investors hoping to generate gains over the long term.
But it’s more than hope. It’s a ticket of admission into the capitalist system. That might sound a bit grand, but the reality is that the stock market is simply a representation of our capitalist society in action.
We buy goods or services that companies sell. If Company A is able to create a good or a service that is either better or cheaper than the competition, that company will thrive as they’ll gain more customers.
As a company gains more customers and generates more revenue, investors will want to buy in and this raises the price of the stock. If Company B arrives on the scene and offers the same goods and services which are better or cheaper, more customers will jump ship and eventually, investors will too.
That’s all there is to it.
To believe that the stock market as a whole can crash and never recover means that you believe there will be a fundamental change in the way our society functions. Say Company A and B are supermarkets, Tesco and Sainsbury’s. We may switch from shopping at one or the other. We may start going to Asda or Waitrose.
But is it realistic to believe that we will stop going to the supermarket altogether?
Individual companies can come and go and even whole sectors can come under pressure. Markets can fluctuate widely depending on what is happening in the world. But overall, it has to come back eventually because we will all continue to spend our money somewhere.
Once you understand this fundamental idea it becomes a lot easier to see how we can be so confident that, over the long term, the stock market is almost sure to provide attractive long term returns for investors.
The stock market can also predict the future. Ok, ok, it’s not going to give you next week's lottery numbers and it’s by no means perfect, but in economic terms it’s what’s known as a leading indicator.
A leading indicator is something that takes into account projected information from the future, and can therefore provide a (very rough) prediction on what the future might look like. We often talk of the stock market as a leading economic indicator, because investors, especially professional ones, base their decisions on what they think the economy is likely to do, not just what it has done in the past.
Let’s consider an example. Say that the overall economic forecast is looking very gloomy. The Bank of England is predicting low economic growth, as is the European Central Bank and the United States Federal Reserve. Unemployment is going up and it’s just generally looking like the next year is going to be bumpy.
Investors will look at this information, and many will start to shift their money out of the stock market and into safer assets like cash and bonds. As more and more investors do this, there will likely be more sellers than buyers which will drive down the stock market and could lead to an all out crash.
All of this can happen before there has been any announcement of poor economic data. In fact, economic growth may have been really strong for the last year. The key factor is that investors look to the future and make their decisions based on what they think is going to happen.
In this example, by the time the economy does start to shrink, the damage has already happened in the stock market. And actually, this can lead to the opposite effect. When the economy is in the doldrums and unemployment is high, the future may start to look a little more rosy.
Those same investors may start to think that the economy is likely to pick up over the next 12 months, and start to move their cash back into the market. This then starts to bid up prices and can lead to a stock market recovery, long before an economic recovery.
This is also why stock markets can sometimes go down after good news is announced and up after bad news is announced. If economic growth has been widely expected to be -2% for the quarter, the stock market will be priced based on that figure. If the number ends up being -1%, that’s better than expected and the stock market would likely jump, even though the economy has still gone backwards.
On the flip side, if the economy is booming and growth is expected to hit 2% for the quarter and it only achieves 1%, the stock market could drop, even though the economy has grown.
When things are looking gloomy and bad news is all around, the instinctive reaction for many investors is to think about how badly it is all going to impact the stock market.
The truth is, it’s almost certainly already ‘priced in’ to the current prices, meaning, all the bad news has been taken into account by investors when making their buying and selling decisions at current valuations.
It’s for this reason that the smartest money in investment circles is always looking to get in during the darkest hour. It’s much easier said than done, but it’s the old, simple investment adage of aiming to buy low and sell high.
It’s one thing for us to say that, but what is this based on? There have been dozens of economic crashes and recessions in the past, and the global stock market has always come back to beat its previous high.
We’re going to look at the US market for this part, because it makes up around 60% of the global market. It's therefore a good proxy for stocks as a whole.
Monday October 19th, was the largest single day stock market decline in history, with the Dow Jones Industrial Average (a barometer for the overall US market) dropping almost 22% in a single day.
The crash came off the bank of a range of different factors and many investors sold out in the panic, losing hundreds of thousands or even millions. Here’s what the returns would have looked like for investors who bought in at the ‘darkest hour.’
2 years on: +54.39%
5 years on: +83.38%
The euphoria of the internet bubble saw companies with almost nothing more than a domain name achieving sky high valuations. With many similarities to the crypto and NFT boom of recent years, prices made no fundamental sense, and the bubble soon popped.
The bust took a couple of years to work through, with the bottom of the market being hit on 9th October 2002. This was a time of immense upheaval with the 9/11 attack also occurring during this period. Investors who’d been brave enough to get in at the bottom were well rewarded.
2 years on: +6.93%
5 years on: +30.99%
For many investors this will be the only past personal experience with a crash or recession. The global property market, and particularly in the US, came under immense pressure and many companies required government bailouts.
It also led to much stricter regulation of the banking system and lasting impacts in relation to interest rates and central bank policy. It was a scary time, but yet again investors who waded in at its worst made significant profits over the long term.
2 years on: +86.54%
5 years on: +150.78%
While you may not be able to pick the bottom, it’s clear that investing when things are at their worst has worked out pretty well in the past. If you’re concerned about your investments or you’d like to discuss this in more detail, we’d love to chat with you. Book in a call with one of our Financial Advisors and we can discuss what the current markets could mean for your financial plan.
If you want further information on how to invest through a recession, you can find a deep dive into the topic in our recent webinar.