Recession: What Does It Mean For Investors

When the economy turns into a tailspin, you may hear reports of falling housing starts, rising jobless claims and falling economic output. How does this affect us as investors? What do house construction and shrinking production have to do with your portfolio? As you will see, these indicators are part of a bigger picture that determines the strength of the economy and whether we are in a period of recession or expansion. (See also “A Review of Past Recessions.”)

The business cycle

To understand the state of the economy at any given point in time, we need to start with the business cycle. In general, the business cycle consists of four different periods of activity, each of which can last for months or years.

Top. At its peak, the economy is in full swing. Employment is at or near its peak, real gross domestic product (GDP) is growing at a healthy rate, and incomes are rising. What is less encouraging is that prices are rising due to inflation. Even so, most companies, workers and investors are enjoying the boom times.

Recession. The old adage “what goes up has to come down” applies here perfectly. After much growth and success, income and employment begin to decline due to a number of causes: an external event such as an invasion or supply shock, a sudden correction in overheated asset prices, or a decline in consumer spending due to inflation – which in turn can cause companies to lay off employees. (Because contractors pay the workers and the prices they charge consumers are “inelastic” or initially resistant to change, reducing payrolls is a common response). Rising unemployment is driving consumer spending further down, triggering a vicious circle of economic contraction. A recession is generally defined as two or more consecutive quarters of decline in real GDP. (See also, “9 General Effects of Inflation”.)

Trough. This is the part of the business cycle when output and employment bottom out. At this point, spending and investment have cooled significantly, and prices and wages have come down. This realignment makes new acquisitions attractive to consumers and new investments – in work and assets – attractive to companies.

Expansion (restoration). During a recovery – or “expansion” if we do not discuss it in the context of the last recession – the economy begins to grow again. As consumers spend more, firms increase their production and lead them to hire more workers. There is competition for labor that drives wages up and puts more money into the pockets of workers (and consumers too). That allows companies to charge more, which causes inflation, which, if weak at first, can eventually stall growth and start the cycle again. However, in the long run, most economies tend to grow, with each peak reaches a higher peak than the last.

Phases of the business cycle

This scheme is, of course, oversimplified: economies, for example, sometimes experience double-dip recessions, where a brief recovery is followed by another recession. Neither do any national economies have a positive long-term growth path. The relationships between expenditure, prices, wages, and output described above are also too simple: Governments often have a large influence on all stages of the cycle. Excessive taxation, regulation or money pressures can trigger a recession. Fiscal and monetary incentives can reverse a shrinking economy if the supposedly natural tendency to rebalance does not materialize. (See also “Industries That Thrive During the Recession.”)

What does this mean for investors?

Understanding the business cycle doesn’t matter much unless it improves portfolio returns. What does an investor have to do during a recession? The answer depends on your situation and which investor you are. (See also “Recession Evidence for Your Portfolio”.)

First, remember that a bear market doesn’t mean there is no way to make money. Some investors take advantage of falling markets by short selling stocks, which means they make money when stock prices fall and lose money when they rise. However, this technique should only be used by experienced investors due to its unique pitfalls. Most importantly, the losses from short sales are potentially infinite: there is no obvious limit to how far a stock can go in value. (See also “Short Selling Tutorial”.)

Another breed of investors treats a recession like a sale at the local department store. This technique, known as value investing, views a falling stock price as a bargain waiting to be bought out. Betting that better times will return to the economy at some point, investors love the bear markets for buying good quality businesses cheaply.

There is another type of investor who barely flinches during the recession. A supporter of the long-term “buy and hold” strategy knows that short-term problems will hardly play a role in the next 20 to 30 years.

Of course, only a few of us have the luxury of looking for decades across the board, or the iron stomach that does not have to do anything in view of the enormous paper losses. Value investing is not for everyone as it requires extensive research, while short selling is an even tougher discipline than buying and holding. The key is to understand your situation and choose a style that works for you. For example, if you are about to retire, the long-term approach is definitely not for you. Instead of relying on the stock market, one should diversify into other assets such as bonds, money market and real estate.

The bottom line

Reading the headlines during a recession can convince you that the sky is falling. But downturns are a normal part of the business cycle, and it is important to develop a strategy for dealing with them based on your financial situation and risk appetite after the recession.

by Abdullah Sam
I’m a teacher, researcher and writer. I write about study subjects to improve the learning of college and university students. I write top Quality study notes Mostly, Tech, Games, Education, And Solutions/Tips and Tricks. I am a person who helps students to acquire knowledge, competence or virtue.

Leave a Comment