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Why do share prices fall in recessions?

Equity analyst, William Ryder, goes back to basics to explain why stocks fall in recessions, and why they have tended to recover.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

In a recession, society’s output and consumption falls. This means fewer goods and services are produced, incomes fall and people lose their jobs.

The IMF is currently projecting a 3% fall in global GDP in 2020, and a 6.5% fall in the UK. This would be the world’s “worst recession since the Great Depression, and far worse than the Global Financial Crisis.”

But that assumes the disruption peaks this quarter and economic activity recovers in the second half of the year. If the lockdowns last longer, the IMF thinks the economic damage will be even worse.

While we don’t know exactly where we’re all headed, it’s safe to assume the current lockdown is reducing overall economic output. A recession of some severity doesn’t seem too much of a stretch.

Why do stocks fall in recessions?

There are three main reasons share prices fall during recessions and other periods of uncertainty. We’ve seen these play out during the last few weeks in response to the COVID-19 pandemic.

  1. Company profits are expected to fall, so the shares are worth less
  2. Uncertainty has increased, meaning stocks are riskier and worth less
  3. Investors want to take less risk, so they sell shares to hold safer investments like bonds or cash

1. Earnings expectations

People spend less during a recession, meaning many companies suffer a loss of revenue and profits in the short term.

But share prices are driven by investors’ expectations of all future earnings, from now until forever. This means the path of future earnings also matters. If investors expect corporate earnings to bounce back quickly, share prices won’t fall by too much. But if investors think the recovery will be much slower, then shares will fall that much further.

Ultimately though, expectations for future profits can only explain part of the fall we’ve seen in share prices and they could fall further.

2. Uncertainty

The COVID-19 pandemic has not only lowered our expectations for future earnings, but also dramatically increased the uncertainty of these expectations.

A common measure of uncertainty is market volatility, or how large the daily price swings in the market are. If expectations are changing rapidly the market will move around a lot. This implies that investors are less certain about what’s actually going to happen.

Volatility in the FTSE All-Share

This chart shows the daily percentage change in the value of the FTSE All Share. The daily swings increase dramatically in March when the impact of COVID-19 became widely recognised.

Source: Refinitiv, HL, 15/04/20

All else being equal, investors will pay more for safer assets than they will for riskier ones. This is because investors demand higher returns to take on extra risk. This extra return is known as a “risk premium”, and it’s why the return on stocks has historically been higher than the return on government bonds.

When the future is less certain, as it is today, risk increases. For investors to get a higher return to compensate them for this increased risk, they must buy in at lower prices. So share prices fall until investors think they’re likely to get a reasonable return in exchange for taking the extra risk.

3. Risk appetites

Apart from actual risk increasing, investors’ willingness to take risk can vary in different circumstances. Many readers will understand this intuitively, especially while living through a pandemic.

If you’re investing for retirement and have a secure job, the month-to-month value of your portfolio isn’t really that important, although it is uncomfortable to see your investments fall in value. If you’re not planning to sell your investments any time soon, you can take a long-term view and be patient. What matters is the long-term performance of your portfolio, not the short-term swings.

But what if you lose your job in a recession or suffer a loss of income thanks to a pandemic? You might be forced to draw down on some of your investments if you run through your cash reserves.

In this scenario, which many investors are experiencing right now, buying assets like stocks that might fall dramatically in value seems way too risky. Some companies even risk going bust, and their shares have tended to fall especially heavily as investors sell to avoid the possibility of a total loss.

In these situations, investors often look for security and stability, even if that means a lower return. So, they may sell shares and hold lower-risk investments like cash or government bonds instead. When enough people think like this the market will fall as investors sell out.

The opportunity

If earnings expectations have been lowered and risk has increased then stocks should be worth less. So why have past crises always looked like buying opportunities in hindsight?

I think it’s because the “risk appetites" part of the story is far more important than most people realise.

We know that the price you pay for an investment relative to the fundamentals plays a huge role in the subsequent returns you get.

If investors’ attitudes towards risk can lower share prices, then these attitudes can cause prices to fall further than may be justified. Investors that buy in at the lower prices should get a higher return going forward, all else being equal.

Once the economy recovers and profits start growing again, expectations will get revised upwards and uncertainty will decrease. These also contribute to a recovery in share prices. However, it is worth remembering that the path to recovery could be uncertain and it may well be a bumpy ride. Unlike cash, investments will fall as well as rise in value, so you could get back less than you invest.

The hard truth

Stocks are always higher-risk investments. Although we didn’t see this coming, the risk of a pandemic was always present, and we’ve had some near misses with SARS, Swine Flu and Ebola in just the recent past. These risks won’t go away when COVID-19 does. Neither will the risk of recessions, wars or natural disasters.

The question is, what sort of return on your investment do you need to justify taking that risk?

We’ll all answer that question differently, and probably have different risk appetites at different times in our lives. We mustn’t get scared out of investing altogether though. Inflation will eat away at the value of your cash if you do nothing. It is a good idea though to keep ‘rainy day’ cash savings you can easily access for unexpected emergencies and opportunities.

Remember, you don’t need to go all in on stocks. A diversified portfolio should hold a range of different assets, so you can tailor the balance of risk and potential returns to a level you’re comfortable with.

The importance of diversification in volatile markets

What matters in the long run?

In the short run, markets are mainly driven by investors’ sentiment, meaning their expectations for the future, the certainty of those expectations and their attitude to risk. In the medium term, valuations start to matter too.

But in the long run, what really matters for stock market returns is long-term profit growth and reinvested dividends. If companies keep making more money and shareholders keep reinvesting their dividends, then aside from a really extreme bubble we expect this to far outweigh any valuation changes in the long run.

Stock Market Drops – lessons from history

What has driven UK stock market returns?

This chart breaks down the annualised return on UK stocks from 1965 to the end of 2019. Past performance is not a guide to the future.

Source: Refinitiv, HL, 14/04/20

As you can see by the graph above, the annualised return on UK stocks from 1965 to the end of 2019 was 12.2%. 6.9% came from profit growth, 0.7% from valuation changes and 4.6% from reinvested dividends. This demonstrates that although valuation changes, expectations and risk appetites can cause the market to swing about wildly in the short term, in the long run it’s profit growth and dividends that count.

As Warren Buffett’s mentor Benjamin Graham is often quoted as saying: in the short term stock markets are voting machines, but in the long run they’re weighing machines.

This article isn’t personal advice. If you’re unsure of whether an investment, or course of action is right for your circumstances please seek advice.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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