Recessions are very unpleasant for many investors. It’s never a welcome event, although theirs is the near-certainty that recessions are always followed by cheerful times.
Defining a Recession
A recession is a prolonged period of significant decline in economic activity. Generally, economists refer to two consecutive quarters of negative gross domestic product (GDP) growth as a recession, but other definitions exist.
Recessions are also the time when faltering confidence is rampant on the part of the consumers and businesses, weakening unemployment, falling real incomes, and weakening sales and production.
Since they relate to the stock market, recessions tend to result to heightened risk aversion on the part of investors and a subsequent rush to safety.
The Bigger Picture
The trick to investing before, during, and after a recession is to focus on the bigger picture instead of trying to time your way in and out of different market sectors and individual stocks.
Even though there’s a lot of historical evidence for the cyclical nature of certain investments during recessions, the fact of the matter is that timing such cycles is beyond the ability of the retail investor.
Macroeconomics
The first thing you have to do is to consider the macroeconomic aspects of a recession and the way they affect capital markets. When a recession hits, companies slow down business investments, consumer slow down their spending, and people’s outlook turn from optimistic to pessimistic and remaining doubtful of the future.
Understandably, during recessions, investors tend to become frightened and concerned about prospective investment returns, and to scale back the risk in their portfolios. The psychological factors manifest themselves in a few broad capital market trends.
Capital Market Trends in Times of Recession
In the equities markets, investors’ perceptions of heightened risk often result to expecting or requiring higher potential rates of return for holding equities. For expected returns to go higher, current prices need to go down, which takes place as investors sell riskier holdings and move into safer securities like government debt.
This is the reason why equities markets tend to fall, often precipitously, ahead of recessions as investors switch their investments.
Investing by Asset Class
History shows us that equity markets have an uncanny ability to serve as the leading indicator for recessions. For instance, markets began with a sharp drop in mi-2000 prior to the recession of March to November 2001.
Investing to Stocks during Recession
When you’re investing in stocks in times of recession, the relatively safest places to invest are in high quality companies that have long business histories since these should be the companies that can handle prolonged periods of weakness in the market.
For instance, companies with strong balance sheets, including those with little debt and healthy cash flows tend to do much better than companies with significant operating leverage (debt) and weak cash flows.
A company with strong balance sheet and cash flow is more able to handle an economic downturn and more likely to be able to fund its operations in spite of the tough economy.
On the flip side, a company with a lot of debt may be obliterated if it can’t handle it debt payments and the costs associated with its continuing operations.