A recession is a prolonged period of significant decline in economic activity. In general, economists refer to two quarters of negative gross domestic product (GDP) growth in a row as a recession, but there are also other definitions.
Recessions are usually sprinkled with faltering confidence on the part of the consumers and businesses, weakening employment, falling real incomes, and weakening sales and productions. Obviously, this is not the type of climate where stocks would grow.
Recessions usually lead heightened risk aversion on the investors’ part and a flight to safer assets. On a lighter note, recessions always give way to better days sooner or later.
Focus on the Bigger Picture
The trick to investing before, during, and after a recession is to focus on the longer term horizon instead of trying to time your way in and out of various market sectors, niches, and individual stocks.
Even if there’s a lot of historical evidence for the cyclical nature of certain investments during recessions, timing such cycles is outside or beyond the scope of a retail investor.
Macroeconomics and Capital Markets
You have to consider the macroeconomic aspects of recession and how they affect capital markets. When a recession strikes, companies slow down business investments while consumers slow down their spending.
The market sentiment shifts from being optimistic and expectant of a bullish run to being pessimistic and uncertain of the future.
Understandably, during recessions, investors usually become scared and worried about the prospective investment returns. They scale back risk in their portfolios. These psychological factors show themselves in a few broad capital market trends.
Capital Market Trends
Within the equity markets, investors’ perceptions of heightened risk often lead them to require higher potential rates of return for holding equities.
For excepted returns to go higher, current prices need to drop, which takes place as investors sell riskier holdings and move into safer securities such as government debt.
This is the reason why equity markets usually fall prior to recessions as investors shift their investments.
Investing in Stocks
If you want to invest in stocks during recessionary periods, the generally safest places to invest are in high-quality companies that have long business histories since these should be the companies that can handle extended periods of weakness in the market.
For instance, companies with strong balance sheets: these include those with little debt and healthy cash flows. They usually do better than companies with significant operating leverage and weak cash flows.
A company with a strong balance sheet and cash flow can better handle an economic downturn and more likely to be able to fund its operations despite the tough economy.
For comparison, a company with a lot of debt may be damaged if it can’t handle its debt payments and the cost associated with its continuing operations.
Danger and Diversification
In the same breath, it’s quite dangerous to pile into a single sector, including customer staples. Diversification is particularly important during a recession, when particular companies and industries suffer.
Diversification across asset classes, like fixed income and commodities, aside from equities can also serve as a protection against losses.
Prices in the Forex market can move excessively rapidly, especially during the volatile periods. Before entering a trade, it is essential for you to know what you stand to gain or lose from it.