Should my investment strategy change during a recession?

Canada may have entered a “technical recession,” but that is not a reason for your investment strategy to change.

The relationship between economic data and stock returns is much messier than most people realize for a simple but counterintuitive reason: the stock market prices assets throughout the trading day based on expectations about the future, while news about economic data is backward looking.

A technical recession is defined as a drop in real gross domestic product (GDP) in at least two consecutive quarters. It is worth mentioning that this is not the formal definition of an economic recession.

The C.D. Howe Institute Business Cycle Council, the arbiter of business cycle dates in Canada, defines a recession as a “pronounced, pervasive and persistent decline in aggregate economic activity, typically resulting in a cumulative decline over adjacent quarters.”

Definitional nuances aside, investors tend to worry when they hear the word, “recession.” The concern is overstated, though not completely unfounded. Some historical recessions have been associated with major declines in the stock market, but recessions do not guarantee poor stock returns.

Of the seven economic recessions going back to 1957, three of them had negative stock returns, while the remaining four had positive ones.

Even if I could tell you the exact start and end dates of the next recession, you would not be able to reliably profit from the information. Of course, the fact that I can’t tell you the timing of recessions makes timing the stock market on account of an expected recession that much harder.

Importantly for investors, the three-year and five-year returns after economic peaks – that is, the peak immediately preceding recessions – have been meaningfully positive. Even if the market does decline in a recession, it has tended to bounce back.

Additionally, these are only Canadian data. When Canadian stocks perform poorly during a Canadian recession, there is a good chance that other countries or regions will deliver positive returns. For example, in two of the three historical recessions where the TSX experienced negative stock returns, the S&P 500 delivered positive ones.

While tempting, trying to time the stock market on expectations of a recession has been far from a slam dunk historically, even if you know when the recession will happen.

The relationship between future economic activity and stock returns was studied in depth by Eugene Fama and Kenneth French in a 2019 paper where they used yield curve inversions – which do forecast economic activity with some reliability – to time exposure to the stock market.

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The two economists implement a market-timing strategy that shifts out of equities and into treasuries when yield curves invert. Based on the analysis, Mr. Fama and Mr. French conclude that they “find no evidence that yield curve inversions can help investors avoid poor stock returns.”

This is not a surprising result. Even the most successful economic forecasts do not reliably predict stock returns because those same forecasts are reflected in current stock prices.

Big shifts in stock prices tend to happen when the market’s prior expectations turn out to be materially different from reality. But there is no reliable way to predict future information and how that will match up with current expectations.

The result is a messy relationship between the economy and the stock market, and an important takeaway for investors: Trouble in the economy does not necessarily mean that your investments should change course.

Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.