Can the stock market collapse without a recession?

Summary

- A “recession” is usually defined as two consecutive quarters of gross domestic product (GDP) contraction.

- Stock market collapses are generally believed to be associated with economic recessions.

- We show that this is not the case, based on data from Australia.

- Even though Australia has experienced uninterrupted GDP growth from 1992 to 2018, its stock market dropped by around 67 percent from late 2007 to early 2009.

The case of Australia

The picture below shows two charts prepared with data from Tradingeconomics.com (). The top chart shows the growth in gross domestic product (GDP) in Australia from 1992 to 2018. The bottom chart plots the S&P/ASX 200 index during the same period. This index is maintained by Standard & Poor's and is seen as the benchmark for Australian equity performance; much like the S&P 500 in the U.S.A.

Note that the index fell by approximately 67 percent from late 2007 to early 2009. This stock market collapse was more severe than the one experienced in the U.S.A. around the same time.

The period from late 2007 to early 2009 broadly coincides with the period widely known as the Great Recession ().

Yet, there was no economic recession in Australia during that period. What happened was a decrease in the rate of GDP growth; from between 4 and 5 percent, down to between 1 and 2 percent.

If GDP growth slows down, earnings growth is also likely to slow down

When GDP growth decreases but does not turn negative, GDP continues growing – but at a slower pace. The growth in company earnings tends to also decrease during such times, even though earnings may continue growing.

Because of various amplification factors – such as impaired consumer confidence, aggressive competition, and higher interest expenses – earnings growth may decrease much more than GDP growth.

A decrease in GDP growth from 4 to 2 percent may lead to a much wider decrease in average earnings growth for a subset of the market (e.g., from 20 to 2 percent), causing a widespread panic about valuations for the entire market.

PE-based valuation

Let us illustrate this through a plausible scenario. An investment of $10,000 will generate a 100 percent return (i.e., approximately double in size) in 9 years if made in shares of a company whose price-earnings (PE) ratio is 26, and whose yearly earnings growth is 20 percent. If yearly earnings growth drops to 2 percent, which is essentially no real growth at a 2 percent rate of inflation, the same investment will double in size in 9 years only if the PE ratio drops down to 12.

In the scenario above, a PE of 26 would have to go down to 12 for a comparable PE-based valuation of the company to be achieved. That is, at a PE of 26, the company would suddenly look very expensive.

The PE drop from 26 to 12 is of approximately 54 percent. That would typically translate into a big short-term decrease in market capitalization, and a big loss to investors, even with mitigating actions such as share buybacks and dividends.