How bad can it get if the US falls into recession?
NEW YORK (AP) — Are investors overreacting to the prospect of a recession?
The slightly better jobs report on Friday notwithstanding, the odds of a recession appear to be climbing, and that's bringing back scary memories. Though stocks may look cheap thanks to record corporate profits, that was also true the last time the U.S. was heading into a downturn. Based on recent recessions, profits could fall a third if the economy crumbles.
Investors have been worried about a new recession for months. Headlines last week ratcheted up the fear.
On Tuesday, the Federal Reserve Chairman Ben Bernanke testified to Congress that the recovery is "close to faltering." Goldman Sachs said Europe could fall into recession by the end of the year, and push the U.S. "to the edge" of one itself. A co-founder of the Economic Cycle Research Institute, a forecasting firm that called the last three downturns, made the rounds of TV news shows to say a U.S. recession was all but inevitable.
With memories of the Great Recession so fresh, investors are understandably spooked. A year after that downturn began in Dec. 2007, profits at companies in the Standard & Poor's 500 index turned into losses. Three months after that, stocks hit bottom at half their pre-recession peak.
But recessions come in many varieties, and most are less scary than the last one. A review of past ones shows that:
— Profit drops range widely. From peak to trough, profits at S&P 500 companies, excluding financial firms, fell an average 32 percent in the past five recessions, according to Adam Parker, U.S. equity strategist at Morgan Stanley. He excludes financial firms because their record write-offs in the last recession turned S&P profits into losses, and would exaggerate the drop at the average company in the index.
The biggest fall in profits: 57 percent from the peak before the 2001 dot-com recession. Profits during the 1981-82 recession fell 17 percent.
— Recessions usually last less than a year. A recession that began in January 1980 was over in six months. The Great Recession that ended June 2009 lasted 18 months, the longest since the Great Depression. The 11 recessions since World War II averaged 11 months.
— Stock investors can get clobbered, but not always. Bear markets that accompany recessions have pulled stocks down an average 38 percent in the last five downturns, based on data from Sam Stovall, chief investment strategist at Standard & Poor's. From their October 2007 peak before the last recession, stocks fell 57 percent. But in the bear market during the recession that began in July 1990, they fell only 20 percent.
— By the time the economy falls into recession, much of the damage to stocks is usually over. The stock market famously looks forward six to nine months, and that's mostly true on the cusp of downturns, too. Stocks had been dropping for a year by the time the 2001 recession began. That's worth remembering if another recession is coming. The S&P 500 is already down 15 percent from its recent peak in April.
Problem is, not even experts who study downturns can predict exactly what kind of recession may come next. "Everyone wants a recession playbook, but there aren't enough similarities with prior cycles to know which one to pick," says Morgan Stanley's Parker.
To be sure, most Wall Street analysts and economists think one isn't even likely now. Jim Paulsen, chief investment strategist at Wells Capital Management, notes that recessions are typically preceded by what he calls "excesses" that need to be purged from the economy. He doesn't think that's true today.
"Have banks been aggressively overextending loans? Has anyone been borrowing too much lately? Are companies overstaffed?" Paulsen writes in a recent report. "It's hard to see why the U.S. would experience a recession when almost nothing requires a correction."
Even if he's wrong, investors bracing for a downturn on the scale of the last one may be pleasantly surprised.
In the Great Recession, the output of many countries shrank at the same time, punishing earnings of U.S. companies that had hoped sales abroad would soften the blow from lower U.S. sales. Fear spread that banks wouldn't make good on their own loans, and that led them to stop making loans to businesses of all kinds. Companies cut more than 600,000 workers a month for six months in a row. With fewer jobs, people had less money to spend and companies sold less, which led them to cut more jobs.
How likely is a repeat?
Banks have fatter cushions against losses now than before the financial crisis. Companies in the S&P 500 are making more money than ever, and squirreling away some as cash reserves, a sort of rainy-day fund. They've laid off so much staff and are running so lean, it won't be as easy to cut jobs like they did in the last recession.
The government reported Friday that non-farm payrolls rose 103,000 in September, better than expected but not enough to lower the unemployment rate. That rate held steady at 9.1 percent.
So if a recession is coming, how bad might it get? That depends on whether the U.S. falls into one alone or together with other countries as it did the last time.
Parker, of Morgan Stanley, is a sort of grim optimist. He doesn't think stocks are the bargains that Wall Street analysts claim. But he doesn't think a worldwide downturn that would send them plummeting is likely, either. If a U.S. recession is coming, he thinks the odds favor a garden-variety one. He says profits for S&P 500 companies could fall to maybe $85 per share in 2012, a quarter below the $112 that analysts expect now.
That could still hurt stocks. But since they're down already, the fall from here might qualify more as a slide than a crash.