Three Things to Know About Recessions

Last Edited by: LPL Financial

Last Updated: November 10, 2022

3 Important Things to Know About Recessions

If the economy does enter a recession, the causes and potential outcome will be hotly debated. At LPL Research, our starting point is always looking at history. In the latest LPL Street View, LPL Chief Economist Dr. Jeffrey Roach discusses three things to know about recessions.

First, a recession has an important technical definition that’s different than what many people think. Earlier this year when growth was negative, many were under the false impression that two consecutive quarters of negative gross domestic product, or GDP, imply a recession. Often that view is a good general approximation, but it isn’t the technical definition. The official definition of a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”  Now for most investors, this definition does not sound very helpful and raises more questions than it answers about things like the meaning of “significant.”

The three factors for defining a recession are depth, diffusion, and duration – conveniently referred to as the “three D’s.” Depth refers to declining economic activity that is more than a relatively small change. Diffusion describes an economy that has experienced a contraction in a wide range of sectors, such as trade, business activity, and consumer spending. Duration is likely the least important of the three D’s and measures the time between the previous business cycle peak and the following trough. Given the unique cause of the 2020 recession, the time between peak and trough was the shortest on record at only two months.

The second thing to know about recessions is that we do have warning signals which usually precede a recession.  They are:

  • Consumer metrics, specifically real spending and personal income, give investors an early read on the health of the consumer and are good warning signs.
  • Employment activity, as reported by both businesses and households, begin to decline before the onset of a recession.
  • Industrial production often stalls near the beginning of a recession, indicating cracks in the business sector.
  • Indexes such as the conference board’s Leading Economic Index give early broad-based warnings about market conditions and are historically good leading indicators.

One reason we see healthy debate on the likelihood of recession is that for most of this year, not all metrics were flashing warning signs. However, recent data may give us more clarity. The Conference Board’s leading index as of September has declined seven out of the last nine months, showing that the economy could enter a period of broad-based contraction. The decline is predictable as many sectors, such as housing, started slowing months ago. Since the inception of the index, a decline of this magnitude over a six-month period has always foreshadowed a recession in subsequent quarters. As such, we think recession risks appear more probable by the beginning of next year. If the economy does fall into a recession, the cause will likely be from the consumer sector retrenching after years of inflationary pressures, high housing costs, and slow real wage growth.

Third, and probably the most important thing to know, is recessions historically have not perfectly coincided with market declines. Bear markets, defined by a market decline of at least 20%, and recessions overlap but investors should remind themselves that markets are forward-looking, so current market volatility is often about future recession risk. As predictable as this slowdown is, the markets have likely priced in much of the slowdown, but that remains to be seen. Taking a broader look at the markets than just officially designated recessions, we know historically that after a negative shock, the following 12-month equity returns are positive. History may not repeat itself, but it often rhymes, so during these contentious times, investors should remind themselves of the three things to know about recession.

You may also be interested in:

Read. Listen. Watch.

Keep up with economic insights from the LPL Research team. Read Weekly Market Commentary. Listen to Market Signals Podcast. Watch Street View.

LPL Newsroom

Thought leadership. Advisor stories and tips. And, Research. Find the latest insights from advisors, what’s new for advisors, and the latest from LPL Research.

LPL’s Thought Leadership Series

Throughout the year, LPL’s Thought Leadership team takes a look at those things that impact and help advisors, providing advisor stories and advisor solutions.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth in the podcast may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. All indexes are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

All index data is from FactSet.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

This Research material was prepared by LPL Financial, LLC. 

Member FINRA/SIPC

For Public Use — Tracking # 1-05346083