Zaks Investment Advisory Service

Recession and How it Affects the Stock Market

Today, I was planning to complete a series of programs about Russia’s economy and financial system, but developments on our own stock markets have forced me to postpone that program until next time. The problem is that the market last week suffered a heavy decline (the S&P 500 index, for example, lost six percent), and now it stands below the level at which it started 2007. The press is mostly focused on one subject: the looming recession. I would like to go through all these things one by one.

Obviously, nobody likes it when the market falls. But unfortunately, the fact that it sometimes does is inevitable. We know that there is a chance the market might fall even before we invest our money. We hope that this will not happen, but know that it might. Moreover, we understand that the fall will be unexpected. Foreseeable situations are not risky: they may be avoided. For example, in one program I talked about how a poorly-diversified portfolio is risky, while failing to deliver additional returns: if you can avoid a particular risk (in this case, by diversifying your portfolio), the market does not reward this risk with additional potential returns. But the risk associated with a possible market fall is impossible to avoid. In October 2007, just four months ago, the market hit record highs. At that point, we could not predict a 15 percent fall. We may only hope that the market climbs back up as quickly as it fell. But unfortunately, there are no guarantees that it will. I hope that all investors understand this and only invest money in the market the amount that they can afford to risk, up to a certain extent. In practice, this means that you will not need this money in the immediate future – for example, within the coming three years. By the way, even though the market has just suffered a very substantial fall, those who invested money three years ago in a widely-diversified stock portfolio have earned about 5.4 percent per annum. Those who invested their money five years ago – about 10 percent per annum. Of course those who invested just recently have lost quite a bit, but these are theoretical, paper losses: I hope that these people invested their money for several years rather than a matter of months, and, as usually happens, will see a nice return in the end. Investors who are approaching the day when they might need their money should be reallocating a part of their investments from stocks to bonds (bonds are significantly less risky instruments and their prices do not vary as much), and then – into short-term money market instruments.

But let us return to the economy. It has been all but impossible to avoid hearing the word “recession” in recent days. Is our economy slipping into recession? Ben Bernanke, the head of the Federal Reserve, appeared before Congress several days ago and said that he did not think so. Nevertheless, he also said the economy was experiencing difficulties and that he, Bernanke, would welcome temporary fiscal measures aimed at helping the economy out. What is a recession? By definition, it is a state in which the economy contracts over two successive quarters (i.e. half a year). Very often, economists are unable to determine with any precision whether the economy is in recession or not, and its exact timeframes are often established only after the economy pulls out of the slide. The last recession occurred in 2001, from April through November. Before then, there was a recession in 1990-91. It cost George H. W. Bush his reelection. There were two successive recessions in the early 1980s: first a brief one from February through July 1980, and then a longer one stretching from August 1981 through November 1982. And a prolonged, heavy recession linked to the oil crisis occurred at the end of 1973. The market only managed to climb out of that one in March 1975.

Recessions do not always affect the stock market. Very often, internal stock market price fluctuations are larger than those prompted by recession. For example, prices fell by about 13 percent during the 1960 recession before quickly returning to their old levels. Less than two years later, in the middle of 1962, while the economy was in a decent shape, they fell by nearly 40 percent at one point, and then quickly climbed back up. The famous fall of October 1987 was not even linked to any recession talk at all. Meanwhile, the 2001 recession only exacerbated the market’s problems, but doubtfully was their main cause: for the most part, a fall that began in the second half of 2000 and lasted for two years resulted from markets overheating at the end of the 1990s. Interestingly, the market usually begins to rise long before the end of recession, as if predicting economic growth.

But of course, recession is a very serious problem. It leads to a rise in unemployment and a fall in the public’s purchasing power. The Federal Reserve, the Administration and Congress would all like to avoid it. Ben Bernanke has already said that the Federal Reserve will be lowering interest rates. This will help both the credit system, which is currently undergoing stress, and the economy as a whole. Unfortunately, lower interest rates will not have a quick effect on the economy – it will take time. Temporary fiscal measures meant to stimulate the economy produce much faster results. The crux of the idea is this: people prefer not to spend money during hard times, saving “for a rainy day” instead. And this hurts the economy even more: what we, the consumers, spend makes up two-thirds of our entire economy, i.e. the gross domestic product. In order to give people an opportunity to spend extra money, President Bush has proposed refunding some 150 billion dollars to taxpayers. I am not sure that Congress will like this idea too much, which means that most likely, certain specific measures will only be adopted several months from now, when the economy begins to pull out of crisis on its own.

And with this, we will draw today’s program to a close. Next time, we will return to our discussion of Russia’s financial markets and the opportunities the present to US investors. This was Sergey Zaks. Thank you for your attention and until next time.