Is the S&P 500 Bear Market a Recession Warning? Here's What History Says.

Three years have passed since the pandemic gained global attention, but its ghost still haunts the economy. Business closures meant to slow the contagion hit global supply chains like a wrecking ball, leading to widespread inventory shortages across many sectors.

Meanwhile, the federal government doled out trillions of dollars in stimulus payments and the Federal Reserve kept interest rates near historic lows to buoy the economy.

In hindsight, those efforts created a situation in which too much demand was chasing too little supply, and any economics textbook could have predicted what happened next: Prices skyrocketed. Inflation hit a four-decade high in late 2021, then proceeded to notch new highs through mid-2022. The Fed eventually walked back its belief about inflation being transitory, and it has since effected its most aggressive series of interest rate hikes since the early 1980s.

Yet inflation remains elevated and unemployment is near a five-decade low. Those indicators portend more rate hikes, and that has Wall Street on edge.

High inflation and rising interest rates have already dragged the S&P 500 into a bear market and brought about a sharp decline in economic output, a trend that is expected to intensify this year. But investors are worried the economy will tumble into a full-blown recession. Is the S&P 500 bear market a warning? Here's what history says.

The correlation between recessions and bear markets

The National Bureau of Economic Research is the authority in this space, and the organization defines a recession as "a significant decline in economic activity spread across the economy, normally visible in production, employment, and other indicators." Put another way, a recession is the period of economic contraction that takes place between the peak and trough of a business cycle.   

The chart below details the approximate start date and end date of every U.S. recession in the last four decades.

Source: National Bureau of Economic Research.

The S&P 500 is a financial index that tracks 500 large-cap U.S. companies that span all 11 market sectors. That diversity makes it a good benchmark for the broader U.S. economy, so investors naturally get nervous about a recession when the S&P 500 drops into a bear market.

The chart below details the start date and end date of every bear market in the last four decades.

Source: Yardeni.

During the last four decades, every bear market except one has preceded a recession by no more than 12 months. No recession followed the brief bear market that began in August 1987, though economic output increased less than 1% in the third quarter that year.  

Also noteworthy, the recession that began in July 1990 was not preceded by a bear market, but it was a very near miss. The S&P 500 slipped into correction territory in July 1990, and the broad-based index ultimately fell 19.9%, meaning it missed the definition of a bear market by a mere 10 basis points.

So, does the current S&P 500 bear market portend a recession? Not necessarily. Bear markets have been a somewhat reliable recession indicator over the last four decades, but there are exceptions to every rule. Investors should hope for the best but plan for the worst.

With that in mind, two more important lessons are buried in the charts above. First, the S&P 500 had already reached a bottom when three of the last four recessions ended, so investors who waited for the economy to improve missed part of the rebound. Second, the economy has recovered from every past recession, and the S&P 500 has recouped its losses from every past bear market.

Time to invest in the stock market

Some investors prepare for a recession by selling stocks. But those investors are setting themselves up for failure. During the last two decades, half of the S&P 500 index's best days took place during a bear market, and another 34% took place during the first two months of a bull market (i.e., before it was clear the bear market had ended).

So what? Missing a few of the market's best days can be very costly. The S&P 500 produced an annual return of 9.4% during the 20-year period that ended in January 2022. But the annual return drops to 5.2% if the 10 best days are excluded, according to JPMorgan Chase.

That means anyone who stayed fully invested in an S&P 500 index fund saw their money grow 500% over those two decades, but any investors who missed the 10 best days saw their money grow just 176%. In other words, investors who tried to time the market likely paid a high price for sitting on the sidelines.

Here's the big picture: Whether or not the U.S. economy winds up in a recession, now is an excellent time to invest in the stock market. And an S&P 500 index fund is a particularly attractive investment idea because the index has always recouped its losses.