Summary:
- If we look at the current state of the economy, there are signs that a recession is looming on the horizon.
- We are only one negative quarter of negative Gross Domestic Product (GDP) growth away from reaching falling into recession.
- The stock market is likely to experience depressed stock prices during a recession, and it may take some time for prices to recover.
- Investors become more risk-averse and are less likely to invest in stocks, leading stock prices to fall during a recession.
If you’re like me, then your eyes have probably been glued to the stock ticker this past week — and not because of any desire to learn about the economy. My fascination stems purely from a fear of losing a massive amount of dollars on my portfolio.
And judging by the pounding that the stock market has endured over this past week, I’m certainly not alone, as shown in the Fear & Greed Index measurement by CNN:
The thing is, only one year ago, the words “recession” were not even in people’s vocabulary. But now, you can’t read the news or turn on the television without hearing about how we are likely heading into a recession. In this post, I will try to break it down and explain how a recession affects the stock market so that you, as an investor, will have all the information you need to make informed financial decisions for your future.
But before we jump into it, let’s talk about what a recession is just so that we are clear about the fundamental reasons and impact behind it…
What is a Recession
Long story short, a recession is when the economy as a whole slows down. This can be due to many factors, such as a decrease in consumer spending, unemployment, supply shock, an increase in interest rates, or other indicators. A recession begins when GDP growth falls below trend (usually defined as ~2%) for two consecutive quarters. Recessionary periods are often accompanied by a bear market, which is defined as a 20% decline in the stock market.
According to NBER data, the average U.S recession duration has been about 11 months. However, the recent recession lasts about two months (COVID-19) but can sometimes extend to several years.
How Does a Recession Affect the Stock Market negatively?
During a recession, there is often a decrease in consumer spending and an increase in unemployment (since an increase in interest rate is thought to impact consumer spending).
As a result, businesses tend to earn less money and may start to experience financial difficulties. This can lead to a domino effect, with more businesses failing and more people losing their jobs. Hence, the stock market is likely to experience depressed stock prices during a recession, and it may take some time for prices to recover.
According to Brent Donnelly, President of Spectra Markets:
Additionally, investors become more risk-averse and are less likely to invest in stocks, leading stock prices to fall during a recession. It’s evident that the real challenge for the Fed is to find the balance between interest rate hikes and unemployment.
How the Stock Market Perform during the past Recession
People often ask how the stock market performs during a recession. The problem is that every recession happens for a particular reason and under unique circumstances. As a result, it doesn’t make sense to compare one recession to another.
The chart below shows S&P 500 Historical Annual Returns during the 1973, 2001, and 2008 recessions:
For example, the Great Recession of 2008 was caused by the housing market crash. This was a once-in-a-lifetime event that is not likely to be repeated. On the other hand, the 2001 recession was caused by the dot-com bubble bursting.
So while it’s helpful to look at past data, we must be careful not to draw too many conclusions from it.
If you are interested in learning more about How Stocks Perform Before, During, And After Recessions based on history, click the link here, where the author has done an incredible job explaining recession.
Now that we have dived into the past, let’s understand…
The Current State of the Economy
Undoubtedly, negative GDP growth, inverted yield curve, rising inflation, and supply chain disruptions remain the leading signal for a recession in today’s market.
If we look at the current state of the economy, there are signs that a recession is looming on the horizon.
The Federal Reserve has been pushing interest rates up, which will make it more expensive for businesses and consumers to borrow money. This will slow down economic growth and may lead to higher unemployment.
We are only one negative quarter of negative gross domestic product (GDP) growth away from reaching falling into recession.
What does a recession mean to the stock market?
According to Jurrien Timmer, there “looks to still be some further downside for equity valuations.”
What really concerns me is that we could still be some way off from reaching the bottom. The stock market is likely to remain volatile as investors try to navigate through the economic uncertainty in the short term. However, over the long term, the stock market has always recovered from recessions and reached new highs.
So while it’s essential to be aware of the risks that a recession poses to the stock market, it’s also important to remember that the stock market has always bounced back in the past.
Ways to Protect Yourself from a Recession
With all that said, that doesn’t mean you have to sit on the sidelines and watch your investment portfolio shrink. There are things you can do to protect yourself from a recessionary downturn.
If you’re worried about a recession, the best thing you can do is diversify your portfolio and make sure you have a mix of different asset classes. This will help protect your portfolio from any sharp downturns in the stock market.
It’s also essential to keep your investment horizon in mind. If you’re closer to retirement, you may not have the time to wait out a prolonged downturn in the market. In this case, it may make sense to move some of your money into less risky investments such as cash or cash equivalents (cash is king in such an environment). On the other hand, if you’re still early in your investment journey, you may be able to afford to take more risk since you’ll have plenty of time to recover from any short-term losses.
No matter your situation, it’s crucial to have a well-thought-out investment plan that considers your risk tolerance and time horizon. By doing so, you’ll be in a better position to weather any economic storm that comes your way.
Final Thoughts
While a recession can have a negative effect on the stock market, it is important to remember that the stock market is always subject to fluctuations. Over time, the market typically recovers from any temporary setback.
If you’re concerned about a recession, be sure to diversify your investments and have a solid plan in place. By taking these steps, you’ll be better prepared to weather any economic downturn that comes your way.
What to Read Next
- Growth Stock Investing in 2022: Is It Still a Viable Strategy?
- Where Are We in the Current Market Cycle? May 2022
Disclaimer: I’m not a financial advisor and cannot legally provide investment advice. I have done this study purely out of personal interest in the financial world. Any risk you take in investing money should be taken as just that, a risk. Please do your own research and consider investment services for consultation before investing your hard-earned money.