A popular Wall Street myth is that bear markets are caused by recessions. The contention is as long as the economy isn’t in a recession stock prices won’t drop by more than 20 percent. And since the cheerleaders who dominate Wall Street never predict a recession, it should come as no surprise they never foresee the bear market that always precedes two negative quarters of GDP growth. The truth is Bear markets and recessions do not occur simultaneously, bear markets both predict and help engender a recession to occur.

Typifying this myth is Capital Economics’ Chief Economist John Higgins as he recently argued, “Major declines in the S&P 500 — that is to say, bear markets in which prices drop by at least 20%, which is roughly twice the drop that occurred between 10th and 24th August–have only tended to occur in, and around, recessions…And we doubt very much that one of those is around the corner.” 

But the truth is bear markets always precede a recession–those who argue otherwise have it exactly backwards. The stock market is a forward looking indicator: it anticipates economic activity yet to come, it doesn’t report on economic conditions that are occurring.  

Recent history proves all recessions were preceded by bear markets. Even though the market is guilty of over anticipating a recession, it has never missed predicting one.

For example, the 1987 stock crash brought the Dow Jones Industrial Average down 508 points, a decline of 23%. However, despite the market’s recessionary signal, the US economy did not enter into an economic contraction at all.

Thirteen years later, record valuations drove the NASDAQ down 78% from its highs in the 2000-02 bear market. The market reached its peak on March 10, 2000, with the NASDAQ topping out at 5,132 during intraday trading. However, the economy didn’t produce a negative GDP print until the first quarter of 2001. If you had waited for validation of an economic slowdown you would have lost a lot of money.