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- Despite the hype, stock market declines make poor indicators of potential recessions
- Understanding how stocks, the economy and the business cycle interact can help broaden your financial understanding
- If a recession does occur, investing in defensive positions, dividend-paying investments and real estate can help you weather downturns
The stock market continues to encroach on bear market territory, with the S&P 500 down nearly 18% since January. The Nasdaq-100 is already enjoying a picnic with the bears at a six-month decline of 29%. And some investors think that current bond activities paired with rising interest rates spell trouble on the horizon.
During periods of such high volatility, it’s natural to worry about a future market crash or economic recession. That’s doubly true with inflation sitting near 40-year highs and the housing market taking a breather.
But actually, stock market declines are poor indicators of potential recessions. For instance, the market declined ahead of the 2001 recession, but avoided bear country prior to 6 recessions between 1953-1990. Moreover, a stock market crash flagged three false warnings between 1962 and 1987.
Understanding how stocks and the economy interact can help you deepen your understanding of both. And none of this means you should ignore declining markets – often, they’re a symptom of an underlying problem. (In this case, investor and consumer pessimism.)
And even if you’re feeling good about your future financial prospects, it’s important to know how a recession impacts investors.
Recessions and declining markets
Stock market performance is based on investor expectations, business fundamentals and market cycles. And while we often associate rising stocks with good times and declining stocks with bad, that’s not always true. In fact, 7 of the 13 recessions since 1945 produced gains – not losses.
In other words, a recession isn’t always preceded by a bear market. (Though the two can feed off each other in the wrong circumstances.)
A recession can strike any country at any time and may be caused by economic imbalances, financial crises, pandemics, or trade wars. During these periods, consumer and business spending, employment rates and wages generally drop, leading to decreased economic output.
Additionally, recessions don’t impact economies evenly. For example, necessities like groceries and utilities often perform well, while cyclical industries like travel suffer greater losses.
Recessions and business cycles
Recessions and expansion are both part of the normal economic cycle. Generally, recessions last around 10 months on average, while expansions may last a few months to over a decade.
To understand how a recession impacts investors, it’s useful to understand the basic economic cycle:
- Phase 1 – Peaks: During a peak, the economy enjoys high employment, growing incomes and GDP and moderate to high inflation. The stock market may perform well as businesses enjoy large profits.
- Phase 2 – Recessions: After a period of growth, income, employment and GDP decline. Stock prices may drop as businesses report layoffs and shrinking profits. Markets may become volatile and experience wild swings.
- Phase 3 – Troughs: Once spending and investment activities have cooled, the recession bottoms out. Businesses and stocks move into recovery mode as low prices attract consumers and investors alike.
- Phase 4 – Recovery and Expansion: The economy grows again as wages, lending and spending rise. Businesses hire more workers and advance innovation, prompting inflation to start up low and slow.
The United States – and the rest of the world – is in an unusual place at the moment. While we’ve enjoyed high wage growth and record-breaking business profits in the last year, we’re also facing supply chain shortages in every industry, soaring inflation and sky-high housing and investment markets.
Unfortunately, much of this growth appears to be growth for growths’ sake. In other words, market prices may no longer be supported by underlying fundamentals.
However, none of these headwinds alone are enough to topple us into a recession. Instead, if we face a recession, it will likely be due to all of these factors heating up the economy at once, followed by a harsh correction courtesy of Federal Reserve interest rate hikes. Already, many have predicted that there won’t be a “soft landing” after two years of astronomical profits and performance.
Standing in a position of strength
Despite so many headwinds, many American households are staring down a potential recession from a position of strength.
Though high inflation continues to pinch many in the pocketbook, 2021 also produced the greatest GDP growth since 1984. In fact, the U.S. economy is 3% larger than it was in 2019, even accounting for 2020’s stay-at-home economy.
Moreover, new data suggests that much of last year’s growth wormed its way into Americans’ pockets. According to the latest estimates, the bottom half of the country continues to see gains independent of pandemic stimulus.
After adjusting for inflation, the lowest 50% on the national ladder saw 10.9% labor and capital income growth last year. Thanks to increased employer competition, wage gains positively impacted the bottom 25% of Americans most in 2021. Not to mention, reports from the ADP Research Institute and Labor Department suggest that U.S. wages rose 4% across the board last year.
And if that weren’t enough, the American people now have the infrastructure, skills and training to work from home in the event of potential layoffs.
In other words, if we do see a recession, it won’t be from a position of weakness, but one of strength.
Investing during a recession
But even if your personal finances are fine, it’d be nice to protect your invested capital if the economy declines. And while recession-proof investments don’t exist, some securities and strategies may weather the storm better than others.
Assume the (defensive) position
One way to profit (or reduce losses) in a recession is to take up defensive positions. This strategy is particularly useful for risk-averse and retirement-age investors.
Cash and fixed-income investments like CDs, Treasuries and money market funds can all help preserve your funds. Non-cyclical investments like utilities, healthcare, energy, financial, and consumer goods may also weather declines with minimal losses.
However, if the market rallies, you risk missing out on potential gains.
Buy into dividends
Holding dividend stocks not only minimizes recession losses but can maximize your lifelong returns. Dividends generate passive income that can buff your profits even when prices are low.
In particular, you may seek out dividend aristocrats, which are companies that have increased their dividends annually for at least 25 consecutive years.
When a recession hits and housing prices drop, you have a chance to snap up real estate for cheap. But you don’t have to flip houses or rent properties to profit. Real estate investment trusts (REITs) let you profit off others’ hard work without getting your hands dirty. (Just beware higher tax rates.)
Value investors look at declining stocks as bargains waiting to happen. Betting on quality stocks at low prices means that, when the economy recovers, you may see even greater gains. (Even if they take a few years to materialize.)
Another way to combat a recession is to…not. Many buy-and-hold investors consider recessions little more than short-term declines in their long-term horizon. As such, they primarily buy investments they’re willing to hold through thick and thin and ignore the news.
Don’t let a recession impact you (too much)
It’s easy to become overwhelmed by doomsday headlines in uncertain times. But a deep breath and a reminder of your long-term plan can make life seem less dire. In fact, long-term investors shouldn’t consider recessions a threat – but rather, an opportunity.
Still, that doesn’t make a recession easier emotionally. That’s why you have Q.ai.
With Q.ai’s AI-backed Investment Kits, you can make the smartest moves for the current market, no matter the weather. And with our all-new Gas Spike and Bond Spread Kits, we now have more ways than ever to diversify your holdings.
And don’t forget to turn on Downside Protection for greater financial security and recession risk protection.
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