What does the stock market do in a recession? (+ examples)

If you’re a smart investor who goes out of their way to stay informed (I salute you), getting a clear picture of what is happening in the U.S. stock market isn’t exactly easy right now. It hasn’t been for some time. For instance, you likely heard all sorts of economists last year predict a doom-and-gloom recession … and it didn’t happen. 

Now, you’re hearing the Fed is in a box. You’re also seeing contradictory news stories about the health of our economy. 

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On the one hand, as of the time I’m writing this, the market is trending up. On the other hand, we’re seeing an uptick in headlines about mass layoffs at very large companies — UPS laid off 12,00 employees due to a drop in package volume, and giants like Amazon, Intel, Nike, and others have announced intentions to do the same for various reasons. (In fact, four out of 10 recently surveyed business leaders anticipate layoffs in the coming year.)

In short, folks keep telling you the house isn’t on fire. But if that’s the case, why are you seeing what you think is smoke coming out of a bedroom window?

To nerd out here for a moment, you do need to be discerning about layoff news. UPS laying off employees is a leading economic indicator that the economy is slowing — package volume is dropping because consumers are buying less. Google layoffs, however, are more related to AI than anything else, even if Alphabet leadership is hesitant to say so.

Even if you find yourself reading this when the state of the U.S. economy is much different than it is today, I share this information to illustrate a point critical to understanding what happens to the stock market during a recession. 

Stock market and economy headlines can be misleading

Let’s look at a hypothetical example to show you what I mean. Pretend for a moment that you’ve been watching the stock market trend upward at a healthy rate for four days. Then, on the fifth day, it stalls. On top of that, Microsoft’s earnings report ends up missing by 2%. 

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Now, a headline you might see would be: 

“Microsoft earnings miss, stock market craters.”

As a result, you (the reader) may believe the story of what happened is that Microsoft’s earnings miss is what caused the stock market crater. In reality, although there is correlation, there is no causation. Microsoft did not cause a stock market issue. There may have been massive options trading that’s just not cool enough to be written about. 

With this critical context, let’s dig into the answer to your question of what truly happens to the stock market during a recession. 

The stock market responds negatively to a recession

The above answer may seem a bit on the nose, but it’s the truth. But now, it’s time for us to get nerdy once more. 

Think of our stock market like a scoreboard for the U.S. economy; it represents in a dollar figure what we believe the value of our economy is. However, it’s almost never in equilibrium with the economy. It’s always floating up above it or below it. 

This is the Buffet Indicator (yes, from Warren Buffet), which compares the total U.S. stock market to the total U.S. economy by dividing the U.S. stock market value by U.S. GDP. When you realize the stock market is that scoreboard for our economy, you’ll see that they have a historical mathematical relationship, as shown above. 

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What you’ll also note is that the Buffet Indicator always returns to its historical trend line. And currently, the leading headline of this chart is that U.S. stock is overvalued when compared to the U.S. economy. I talk more about what that means in this article about what the stocks may do this year, if you’re interested. 

How do we define an economic recession?

So sayeth the wise folks at the NBER (National Bureau of Economic Research), the official definition of a recession is when there is a significant decline spread across the economy, lasting more than a few months. The unofficial definition for years, however, has been two consecutive quarters of negative GDP. So, when the economy slows, the value of companies slows, which is reflected in their stock price. 

That’s why investors often say they’re losing money in the stock market when it starts to tank. Of course, many industry folks will respond, “Well, you only lose money if you sell right now, you only lost money on paper,” yadda yadda. 

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Where it gets tricky is that, by the time a recession is announced, most of the damage to the stock market has already been done. Meaning if we were in a recession right now, we likely won’t know about it for another six to nine months, assuming it’s announced at all. Over the past 10 years or so, we’ve seen politics take more of an active role in whether or not a recession is declared. 

For instance, we’re almost positive we had a recession in 2022, but that was not the narrative from the Biden administration. This is not a move that falls along party lines, and we are not making a political statement here — other administrations in recent years have done the same. 

Remember though, this is all retrospective

When we talk about recessions, we are never doing so in the present tense. That’s why we’re more concerned with what’s happening right now in the economy in order to make the smartest investment decisions possible. 

Yes, it is an informative and educational exercise to look to recessions of the past to understand what may happen in the future. But in terms of how we make smart decisions in the present, we watch monthly leading economic indicators — unemployment numbers, volume of layoffs, types of layoffs, stock market valuations, and so on — that we can look at in real-time. 

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Think of it this way. If the NBER were to turn around and announce we had a recession last year, the stock market is not going to move on that information whatsoever. Again, the stock market is the scoreboard of the economy. If the economy falls, the stock market will fall. If the economy grows, the stock market will grow. But this type of direct correlation is something that we see happening over the long run, rather than the short term.