Don’t focus too closely on history to lay out your investing strategy

The news that U.S. GDP has been revised downward, again, doesn’t seem to phase the market as most major indices are trading slightly higher. Clearly the market is looking to move higher through the end of the year as the economy rises like a phoenix from the ashes of the latest recession. In fact the Russell 2000 small cap index has finally broken above the critical 614 level and looking to move higher. The question for small-cap investors is, how far can the Russell run, and how fast? 

In times like this, it’s tempting for small cap investors to look back in history and see how the Russell has behaved in the past during economic contractions and expansions. That is what many investment advisors say we should do. But recessions come in all shapes and sizes, and the most recent recession came with a stock market sell-off that was so severe it defies true comparison.

The Commerce Department reported this morning that third quarter GDP rose at a 2.2% annual rate. The original report two months ago stated that Q3 GDP rose 3.5%, but in November it was revised down to only 2.8%. This latest revision, while not the best news, is still better then the negative 0.7% GDP growth posted in the second quarter.

Now, definitions of a recession vary depending on who you ask. Many will say that a recession’s end is marked by when GDP stops falling – others say when GDP begins to climb again. By both measures we’re out of the recession right now. But when did it begin? Some say two consecutive quarters of negative GDP growth.

The problem with that definition is it restricts defining a recession to a quarter, rather than a month. To achieve greater specificity, the National Bureau of Economic Research (NBER) uses a broader indicator that measures U.S. business cycle expansions and contractions by looking at things like unemployment and domestic production.

According to the NBER, recessions begin when the economy reaches a peak of activity and begins a period of economic contraction that lasts for more than a few months. The end of the recession is marked by a trough of economic activity. Because the definitions of these terms are pretty lengthy, I’m not going to go into detail, check out the NBER website  for more information. The bottom line is this – The NBER has not announced that the recession is over yet. That’s most likely because unemployment is still so high at 10%.

But I’m skipping a discussion of unemployment today because I’m looking at the NBER’s dates for the last three recessions and showing you why this recession was so different. Their website gives the following dates for the last three recessions.

Peak	Trough	Duration	End Announced
July 1990	March 1991	8 Months	December 22, 1992
March 2001	November 2001	8 Months	July 17, 2003
December 2007	??	??	??

Using the NBER’s guidelines, this most recent recession began in December of 2007 when the Russell 2000 was at 768.  By the time the recession was announced in December of 2008, the Russell had already fallen 46% from its peak. By comparison, between the time the preceding two recessions began and were announced, the Russell was up 3% (1990 recession), and fell 2.5% (2001 recession). 

But what investors want to know is how to use this information to predict where things are going, and I’m sorry but I have to disappoint. The reality is that the stock market is a lagging indicator, it takes time for increasing economic activity to trickle down to corporate earnings.      

In the 24 months since the recession began, the Russell has fallen to 350 and clawed its way back to today’s level of 622 – a full 19% below when the recession began.   

Now it could be a while before the NBER comes out and says that the current recession is over, especially if unemployment stays where it is. The end of the prior two recessions weren’t announced until 20 months past when they actually ended, and they only lasted eight months. Between when those two recessions began and the NBER announced they were over, the Russell was down 27% (1990 recession) and was up 2.8% (2001). 

Given that the Russell it pushing higher, despite any conclusive evidence that the recession is over, investors are left wondering where and why it is moving higher as it pushes toward 650 But don’t give in to the temptation to look at history to tell you why. The reality is that this recent recession was unique, and was accompanied by such a severe market reaction that it defies true comparison. 

The markets are heading higher, and they don’t care what history says – weather it’s good or bad.