For our data needs today, we are going to use the Dow Jones Industrial Average going back until 1900. Of course we are aware of the limitations of using the DJIA, however, it does have the important advantage of 114 years of history. This extended history allows us to analyze the Pre-WWII era against the Post-WWII era which one will soon see plays an important role in determining how much the economic environment plays into stock returns. We will also be using the NBER official business cycle dates to determining whether or not the US economy was in a recession or an expansion.
Regardless of whether or not the US was in a recession or an expansion, the average market return during any economic phase is a healthy 24% (figure 1). The median is quite a bit lower at 9% indicating positive skew in the data set. The average max drawdown during any phase is -15%, with median max drawdown of -9% during any phase.
Figure 1 - Total DJIA Series
When we begin our data slicing and break out the returns based on the type of economic phase the US was in, the performance data skews heavily in favor of expansions relative to recessions. In Figure 2, we show the average and median returns when the US is in an expansionary phase. And in figure 3, we show the returns when the US in a recessionary phase.
Looking at these two figures, without a doubt it has been much to be an equity investor during an expansion that during a recession. The average market performance in 60% higher and the median market performance is 37% higher. Just as important, the max drawdown is significantly less in an expansion relative to a recession.
Figure 2 - Expansionary Phase
Figure 3 - Recessionary Phase
We tipped our hand to this earlier, but now let's analysis pre-WWII and post-WWII returns based on economic phase. Doing so we find a couple of interesting characteristics:
- Market performance during different expansions pre-WWII were more similar and had less skewness as indicated by their much closer average and mean returns (Figure 4) compared to the market returns post-WW2 (Figure 6). The max return is higher after WWII and the median return is slightly lower.
- Recessions were harsher to investors prior to WWII (Figure 5). The median market return during a recession was -9% before 1946 while the median market return since is actually positive (3%) (Figure 7). Max drawdown highlights this as well as the median max drawdown was 11% deeper before WWII (26% vs 15%).
Figure 4 - Pre-WWII Expansion Phase
Figure 5 - Pre-WWII Recession Phase
Figure 6 - Post-WWII Expansion Phase
Figure 7 - Post-WWII Recession Phase
So yes, the economic phase matters to equity investors. However, it has mattered less since WWII. Why is this case? There may be myriad of explanations such as companies leveraging technology to ride out the business cycle more profitability or globalization of sales and profits. Or perhaps it has more to do with the monetary policy backdrop, such as going off the gold standard, than it has to do with other factors. Most likely, it is a combination of many reasons working together. Regardless, it is clear the economic phase is still important to equity investors but as we are reminded nearly every quarter by "professional" forecasters, it is anyone's guess as to which phase we are headed.
(source for all data above is from Dow Jones, Gavekal Capital, NBER)
