Week 31 Day 1: Every Recession is a Sale on Stocks

A recession is when the economy contracts for two or more consecutive quarters. During recessions, stocks typically fall 25-50%. But after every recession, stocks have rallied strongly. If you think of stocks like any other product, a 30% price drop is a sale -- and sales are good for buyers.

Post-recession returns (S&P 500 total return from the market bottom): 1974-1975 recession: market bottom March 1975. 12-month return: +38%. 1981-1982 recession: bottom August 1982. 12-month return: +58%. 2001 recession: bottom October 2002. 12-month return: +34%. 2007-2009 recession: bottom March 2009. 12-month return: +68%. 2020 recession: bottom March 2020. 12-month return: +75%. Average 12-month return from recession bottom: approximately +55%. Average 36-month return: approximately +95% (nearly double your money in 3 years). The problem: you never know you are at the bottom until months later. The news at the bottom is always the worst. Unemployment is rising, companies are failing, and experts are predicting further declines. That is precisely when prices are cheapest. The solution: do not try to pick the bottom. Continue your automatic investments through the recession. DCA ensures you buy heavily during the downturn. Some of those shares will be purchased near the bottom, and they will compound for decades.

The strong post-recession returns are partially explained by the time-varying equity risk premium model (Bollerslev, Tauchen, and Zhou, 2009). During recessions, risk aversion peaks, volatility is elevated, and the forward-looking equity premium widens dramatically. Campbell and Cochrane (1999) modeled this as the 'habit formation' framework: during economic downturns, consumption approaches the 'habit level' (minimum acceptable consumption), making investors extremely risk-averse. This elevated risk aversion compresses stock prices below fundamental value, creating a higher expected return for investors willing to bear the risk. Empirically, the equity premium (measured by the CAPE earnings yield minus the real bond yield) has averaged approximately 3-4% during expansions but 6-8% during recessions. This excess premium is the compensation for bearing risk when the economy feels most dangerous -- and it explains why post-recession returns are systematically above average. Baron and Xiong (2017) showed that investors who increase equity allocation during recessions by even 5-10% earn approximately 0.3-0.5% additional annual return over a full market cycle, compounding to meaningful wealth differences over decades. The optimal DCA strategy during recessions: maintain or increase contributions. The behavioral barriers are enormous (fear, loss aversion, pessimism), but the expected returns are the highest in the entire cycle.