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It’s official. On June 8, 2020, the National Bureau of Economic Research (NBER) declared that the United States entered a recession in February of this year. Somewhat anomalously, after falling roughly 33% from its high to usher in a bear market, the S&P 500 Index had rallied nearly 45% from its lows on March 23 through the date of NBER’s recession announcement.
So while it is bad times for the economy, the stock market has regained some of its former euphoria. Investors may be wondering what this means for stocks going forward, and for the investment factors that shape stock returns.
We can’t predict the future—but we can examine history. Our research into how factors performed before, during, and after previous recessions confirms that it’s risky for investors to try to time economic cycles and factor performance.
The Data on Factor Returns and Recessions
The chart below shows the average monthly returns for the Fama-French factors and momentum in a variety of economic environments. The data goes back to July 1926 and includes 15 recessions. The current recession is excluded as it has yet to run its full course.
As we see in the chart’s top row, all factors have positive returns when invested over the long term. Performance differences first appear when we look at returns during economic expansions and recessions. During expansions, all factors are again nicely positive and are statistically and economically significant. The story is somewhat different when we look at recessions: Both the market’s excess return and small size returns are now negative, and value returns are notably reduced.
These results are not surprising, given that the original three Fama-French factors are often called “risk premiums.” The tough times of a recession are typically when investors flee from risky stocks—especially the riskiest beaten down names. Conversely, investors seek out quality companies with good financial health. This helps explain the better returns of the profitability and conservative investment factors during recessions.
Given that we have entered a recession, should investors cut their equity allocation? Or should they move exclusively to larger stocks with good company financial health? The answer to both questions is no, because those moves present their own risks.
Factor performance can change dramatically during the run up to a recession and in the subsequent recovery. We see evidence of these shifts in the final two rows of our chart, which give factor returns before and after recessions. There is no standard definition for these periods, so for consistency and convenience we have chosen 12 months.
Periods before a recession are often marked by euphoria: The Roaring 20’s, the tech bubble of the 1990’s, and the period before the 2008 Financial Crisis are well-known examples. Such an environment is particularly reflected in the strong returns for momentum, as stocks that have done well continue their positive run.
Periods following recessions are often filled with cautious optimism and increased risk appetite. This is when the small and value segments typically put in their strongest performance, reversing their recession blues. Investors who try to time the market risk missing out on these very substantial gains. It’s not just when you get out, but also when you get back in that matters.
One recent example is that when the impact of COVID-19 became clear, the market sold off rapidly. It then rebounded in anticipation that the unprecedented monetary and fiscal stimulus will moderate the economic damage. Investors who abandoned stocks in anticipation of a recession may well have captured all the downside but missed the subsequent rally.
If timing recessions is hard and picking which factors might perform best even harder still, what can investors do? They can fall back on the principle of diversification. We recommend assembling portfolios with broad exposure across factors. As seen in the top row of the chart above, all of the factors discussed in this article have worked over long periods. While they usually don’t all work at the same time, when one is lagging, others often do well.
We also warn against making dramatic changes to portfolios simply because we are in a recession. These moves are potentially expensive in terms of trading costs and the substantial risks of not getting the timing exactly right. The run up to the current recession saw smaller and value stocks lag by historic amounts. If history is a guide, we expect the fortunes of these factors reverse as the current market cycle runs its course. We don’t know when that turning point will come, but when it does, we believe that investors who’ve maintained a diversified portfolio with broad factor exposure will be rewarded for their discipline.
 Recessions are defined by NBER. About 18% of the full period months and 12% of the months since July 1963 are in recessions. The remaining months are not in recessions.
 In two instances recessions were less than 24 months apart, so some months were within 12 months of both the prior and next recessions. To give each month a unique classification, we simply divided the intervening time period in half. The before and after recession periods in those cases had less than 12 months.
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