The semantics of "Recession"

From the Desk of Guy Geldworth:

Note: Guy Geldworth, who holds a CFA, will occasionally collaborate with this blogger on matters concerning the market and economy. Guy will treat the technical part; I will weigh in on the language part--mostly semantics: "the study of the meaning and use of words and phrases, the form rather than the structure, Concise Oxford Dictionary.

Jack Sands: There has been much discussion lately of recession. The "R" word reemerges from time-to-time because markets, after all, are subjected to cycles.

Guy Geldworth: I prefer the word "uncertainty," but will speak to the word you used. By definition, a recession consists of "two back-to-back quarters in which gross domestic product (GDP) declines year-over-year." That's two back-to-back quarters of negative growth, but this is considered a "lagging measure," which is a blunt instrument, in my opinion. Since the early 19th century, there have been roughly six recessions and three depressions. You can also determine what a recession looks like by measuring real GDP, real income, employment, industrial production, and wholesale-retail sales. (Wikipedia).

Jack: So, gauging a recession seems to bear (bad pun) on determining whether certain conditions are met measured by numbers, and if met, when the conditions began and seem to be subsiding.

Guy: Yes. To get a sharper picture of those conditions it's necessary to look at more recent market history since today's economies operate in a much more complex world. Let's look at the market since the mid part of the last century. Since 1960 there have been twelve bear markets, seven of which occurred during a recession. Bear market: "a market that has dropped at least 20% by major indexes from recent highs" (Los Angeles Times); "a market that is accompanied by widespread pessimism. Investors anticipate further losses and are motivated to sell. A bear market is one in which negative sentiment feeds on itself in a vicious circle. The most famous bear market occurred after the 1929 stock market crash and lasted two years." (Wikipedia, the free encyclopedia).

Jack: Besides the numbers, Bear markets seem to deal a lot with sentiment, that is, a feeling of things going bad.

Guy: Yes, if enough people feel bad enough, they will begin acting as though there is a recession (by selling off their equities) which then may assure one.

Jack: Hate to be thick, but it brings me back to our question: What is a recession? It seems to built by both numbers and emotion.

Guy: That's my point. I'll repeat: a recession consists of two back-to-back quarters of negative growth, and let me emphasize often influenced by negative sentiment in a period of uncertainty. That's my story, and I'm sticking to it. But let me continue with the "recent history." Of the seven bear markets that occurred in a recession, the average length of the recession was eleven months. During those eleven months, the average number of months it took the market to hit the trough (its low point) was seven months. The drawdown period from peak to trough (gauged by market charts and technical analysis) during that period was 23.4 months. (Drawdown: "the measure of the decline from a historical peak in some variable; unrealized losses) Concise Oxford Dictionary.

Jack: Depending upon your positions, if you had some idea about this history, the market "rhythms," of recessions and bear markets, you might be able to ride it out without panicking and selling, at least your good positions.

Guy: Now we're getting to the punch line with respect to what's happening presently. An important current fact: the "final number" is not in for Q4 , 2007 (a measure of fiscal fourth quarter growth or lack thereof in the economy. Fourth quarter: November, December, January, 2007). We could be negative right now, but let me emphasize, of the six recessions I referred to earlier, only twelve percent experienced a downturn. (a downturn can be considered to be a consequence of an expansion reaching an unsustainable state, that is corrected by a brief decline). So we may ask, how bad is a "recession" by definition as compared to a non recession? How bad is a downturn, given that downturns are brief?

Jack: OK, now you're talking about the semantics of it all.

Guy: Without meaning to bore you, it's important to further note that the five bear markets that have occurred since 1960 took place in a non recessionary period.

Jack: A lot of negative sentiment.

Guy: Precisely, and the average number of months of the market decline was seven months. The drawdown during that decline, unrealized losses if you didn't sell, was 21%. Pretty scary, especially if you're not familiar with market history and its rhythms. Incidentally, the number of months to recovery from the trough was thirteen months.

Jack: So, if you could hang on, and you sold the dogs, you'd begin to see your balance sheet returning to normal.

Guy: Even advancing if you got in early enough, if your timing was right.

Jack: Still, is it a sign of weakness to go to cash in these environments, or to investments other than pure equities?

Guy: Certainly not. Always have some cash, 10, 15, 20% based upon your age and risk tolerance. We can get to that. The important point here is that if you look at things like sentiment indexes such as the ISE sentiment index, smart money starts working when the index hits historical lows.

Jack: The opposite of what a lot of folks believe. So, we should see higher equity prices by year's end?

Guy: Depends upon your sentiment, and sentiment, in my opinion, should depend upon your reading of fundamental and technical data of companies and economies. Again, if we are negative right now or have been according to our recession formula, and the Fed (Federal Reserve System, the Central Bank of the United States governed by the Open Market Committee) doesn't get over involved, then yes, we should see higher prices for equities. I believe the Fed should hold tight with lowering rates until the next meeting because, although the weak dollar serves some but not all in overseas trade, it dampens the domestic environment, particularly oil which is priced in dollars. It's a domino effect, a weak dollar causes further weak sentiment, further tightening of the credit markets, and on and on.

Jack: So what does a person do in this period of "uncertainty"?

Guy: If I had to make not one, but two points, number one would be: in our current situation, use the word "uncertainty," not "recession," and operate from that "semantic" vantage point in charting your asset allocation and diversification course of action. And while charting that course, my second point: use non correlated measures. (Correlation does not imply causation, that is, correlation between two variables does not imply that one causes the other. Correlation is a logical fallacy that implies that two events that occur together are claimed to have a cause-and-effect relationship. (In Latin: cum hoc ergo propter hoc, or, post hoc ergo propter hoc). If you use a broker or financial consultant, ask what informs their portfolio constructions. If they use a lot of correlations, I'd say find another individual or firm.

Jack: You make correlated measure sound like a kind of voo doo.

Guy: You're not going to get me caught up with that.

Jack: Until the next time, then.

For a further look into the semantics of "Recession"see: "UCLA Experts Don't Buy Recession"

and, "Will the R-Word incite the bears?"