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How recessions impact stock returns

(MoneyWatch) On Wednesday, we saw that being able to forecast recessions wouldn't have been much help for your portfolio. A study by Dimensional Fund Advisors adds to the list of evidence.

Marlena Lee, vice president at DFA, looked at U.S. economic data from 1900- 2010. Over the 111-year period, the U.S. economy grew an average of 3.3 percent in real terms, and the real return to U.S. stocks averaged 8.1 percent. During this time period, there were 21 years when our economy was in recession. During those years, GDP fell an average of 4.4 percent, yet stocks provided an average real return of 11.3 percent, or 40 percent higher than the average real return in all years, and 54 percent higher than the average real return of 7.3 percent in non-recession years.

Lee examined the evidence in 18 other developed markets and found that a timing strategy would have worked in just two, Germany and France -- though the benefit in France was just 0.05 percent.

Lee noted that while economic growth is related to such positive outcomes as higher incomes, greater longevity, lower infant mortality, better education and increased life satisfaction, it's not linked to stock returns. Clearly, stocks can and have provided strong returns during recessions.

As I explain in Chapter Two of "Think, Act, and Invest Like Warren Buffett," investors who sell when the economic news is bad are making the mistake of engaging in "stage-one thinking." Those who engage in stage-one thinking see a crisis and its risks, but can't see beyond that. The bad news leads them to believe that stocks will go lower. Their stomachs take over, they can't control their emotions, panic sets in, and even well-developed plans are abandoned. This stage-one thinking is what led investors to pull out hundreds of billions from stock mutual funds during the last recession.

On the other hand, those who engage in stage-two thinking know that stock prices don't have to move lower because the current price already reflects the bad economic news. They also know that stock prices should only continue to fall if future news is worse than already expected. They understand that it's not whether the news is good or bad that impact stock prices, but whether the news was a surprise, and in what direction.

In addition, they know that while there's no certainty, they do expect that a crisis will lead governments and central bankers to come up with solutions to address the problem. And the worse the crisis gets, the more likely they are to act with urgency and scale. That insight allows them to see beyond the crisis, enabling them to keep control over their stomach and their emotions.

Investors who react to news of recessions also fail to recognize that the market is actually a leading indicator of economic activity. If you could accurately forecast recessions, the time to have sold stocks would be well before the recession actually begins.

The historical evidence presented may be why Warren Buffett, who advises investors to avoid market timing, said the following: "If they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

(Disclosure: My firm, Buckingham Asset Management, primarily uses DFA funds in constructing client portfolios.)