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Sunny with a chance of recession: Weathering the business cycle

By: Tom Goodwin, Senior Research Director

Just as certain indicators of impending weather patterns inform what we choose to wear before stepping outside, statistical indicators that show where the market is in the business cycle can help us prepare to mitigate the risks of an inevitable recession. Our research into how equity markets have behaved in economic expansion/contraction periods in the past uncovered an empirical regularity in how the small cap premium behaves in and around recessionary periods. These historical patterns might prove useful guides for market participants in determining how to reduce recession risk.

The US economy has been in an expansionary phase since it last bottomed out back in June 2009.[1] We have no idea when the current expansion might peak and turndown, but just as clouds and rain are inevitable, so too is a future recession. Although not perfect, the broad US equity market is a well-known indicator of recessions—tending to turn negative just before the economy peaks and heads down. But if we turn the focus to small cap behavior via the small cap premium, a completely different pattern emerges.

The small cap premium represents the return differential between a small cap stock and a large cap stock. It is designated as a premium due to the historical tendency for small caps to outperform large caps in the long run—although that is not always the case in the short term.

To conduct this analysis, we used the last five complete expansionary cycles of the US economy as defined and dated by the National Bureau of Economic Research (NBER), seen in the table below. We are currently in the sixth expansionary period for which the peak has yet to be announced.

To assess the performance of the broad market we use the Russell 3000® Index, and for the small cap premium we use the return differential between the Russell 2000® Index and the Russell 1000® Index. For each of the five completed business cycles shown above, we computed the 12-month forward looking return at nine different points in time—three, six, nine and 12 months before and after an NBER-defined peak as well as at the peak itself. We then took the average return from each business cycle at those points in time and created the bar chart below.

As we can see, the average 12-month forward looking return for the broad US market turned negative nine months before the recession began and stayed close to zero or negative through the beginning of the recession. By contrast, while the 12-month small cap premium also turned negative nine months prior to the recession, it flipped to positive at three months prior and stayed positive throughout the recession.

As anyone who has found themselves soaking wet in an unexpected rainstorm knows, historical statistics are not always reliable predictors. But a look back at history can provide some clues as to how equity markets might behave in and around a recession. While broad market performance as a leading indicator of recessions is nothing new, the behavior of the small cap premium just prior to and during the recession might be surprising. Market participants may find this information useful when navigating future business cycles.

For further detail on how we conducted this analysis, refer to The US Small Cap Premium and the Business Cycle paper.


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[1] As determined by the National Bureau of Economic Research (NBER) as of September 30, 2016. The NBER is a private non-profit US-based research organization. It has no official status, but many US government agencies and economists rely upon NBER dates in its research.

 

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