How does Recession Affect Stock Market?

When the economy is headed for recession, it’s natural for investors to worry about falling stock prices and the impact on their portfolios. At the same time, you can hear reports of declining housing starts, increased unemployment claims, and declining economic output. But what does building a house and downsizing have to do with your portfolio? And beyond all these risks, how does the recession affect you as an investor?

As you will see in this article, these symptoms are part of a bigger picture that determines the strength of the economy and indicates whether we are in a period of recession or expansion. To understand the state of the economy at any given time and how it affects the stock market, we need to start with the business cycle. In general, the business cycle consists of four distinct periods of activity, each of which can last months or years.

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What is a Recession?

A recession involves a period of negative economic performance, often defined as two consecutive quarters of negative real GDP. The official definition of a recession, according to the National Bureau of Economic Research (NBER), is “a significant decline in economic activity spread across the economy, lasting more than a few months, commonly visible in real GDP, real income, employment, industrial production, and wholesale retail sales.”

This definition is useful because it reflects the wide-ranging impact of a recession on the entire economy, from the stock market to real estate prices. And while GDP is a lagging indicator of the economy, the stock market is a leading indicator, meaning you’ll feel the pain of an economic downturn sooner than anywhere else in your investment portfolio.

What are the causes and implications of recession?

A recession refers to a significant and widespread decline in economic activity within one or more countries and may last for more than a few months. It is characterized by a sustained period of decline in various key economic indicators such as gross domestic product (GDP), employment rates, industrial production and business investment.

During a recession, there is a decline in overall economic output, and this decline goes beyond a short-term fluctuation or temporary slowdown.

The causes of a recession can vary, but often stem from a combination of factors such as reduced consumer spending, reduced business investment, a decline in international trade, a financial crisis, or the disruption of certain industries.

Recessions are usually associated with negative trends in the economy, including falling wages, rising unemployment, lower corporate profits, and declines in the value of assets such as real estate and stocks.

Whenever a recession occurs, it means –

• Rising unemployment: A recession leads to job losses and higher unemployment rates, causing financial hardship for individuals and communities.
• Decline in income and wages: Incomes and wages tend to decline during recessions, reducing purchasing power and contributing to income inequality.
• Decreased business profitability: Businesses face reduced profitability due to falling demand, leading to cost-cutting measures and potential closures.
• Stock market declines: Recessions are accompanied by stock market declines and increased volatility, which affects investor sentiment and wealth accumulation.
• Government deficits and debt: Governments often use expansionary fiscal policies during recessions, leading to budget deficits and increases in public debt.
• Impact on the global economy: Recessions can have global knock-on effects, including restrictions on trade, investment flows, and financial contagion that affect economies around the world.

Can You Predict a Recession?

Because economic forecasts are uncertain, predicting future recessions is far from easy. For example, Covid-19 appeared seemingly out of nowhere in early 2020, and within months the Indian economy was almost shut down and millions of workers lost their jobs.

That being said, there are indicators of looming problems. The following warning signs can give you more time to figure out how to prepare for a recession before it happens:

The yield curve is a graph that shows the market value – or yield – of a range of Indian government bonds, from four-month bonds to 30-year bonds. When the economy is functioning normally, yields should be higher on longer-dated bonds. But when long-term returns are lower than short-term returns, it shows that investors are worried about a recession. This phenomenon is known as yield curve inversion and has predicted past recessions.

1. An inverted yield curve: The yield curve is a graph that shows the market value—or yield—of a range of Indian government bonds, from four-month bonds to 30-year bonds. When the economy is functioning normally, yields should be higher on longer-dated bonds. But when long-term returns are lower than short-term returns, it shows that investors are worried about a recession. This phenomenon is known as yield curve inversion and has predicted past recessions.
2. Declines in consumer confidence: Consumer spending is the main driver of the Indian economy. If surveys show a sustained decline in consumer confidence, it could be a sign of impending trouble for the economy. When consumer confidence is down, it means people are telling survey participants they don’t feel confident spending money; if they live up to their fears, lower spending will slow the economy.
3. Sudden stock market declines: A large, sudden decline in stock markets could be a sign of a recession coming on, since investors sell off parts and sometimes all of their holdings in anticipation of an economic slowdown.
4. Rising unemployment: It goes without saying that if people lose their jobs, it is a bad sign for the economy. Just a few months of steep job losses is a big warning of an impending recession, even though the RBI has yet to officially declare a recession.

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How does the recession affect the stock market?

A recession has a directly proportional impact on stock markets. During a recession (when prices fall rapidly), the stock market tends to go through a period of constant decline and increased volatility. This is done for various reasons such as a reduction in consumer spending.

As people face financial uncertainty during a recession, they tend to cut back on their discretionary spending, which directly affects the revenue and profitability of businesses. This decline in corporate profits erodes investor confidence, forces them to sell stocks, and causes stock prices to fall.

Another factor is the growth of unemployment. When companies struggle to maintain operations and profitability during a recession, they often resort to cost-cutting measures, including layoffs and hiring freezes. The resulting increase in unemployment contributes to reduced consumer purchasing power and signals a weakened economy. Investors interpret this as a negative indicator of the future performance of companies, which further pushes share prices down. Investors are more risk averse, seek less risky investments or decide to sell their holdings altogether. This increased selling pressure leads to increased volatility, with prices experiencing sharp declines and frequent swings.

However, there may be exceptions to the general downward trend in the stock market. While overall market performance tends to be negative, certain companies/sectors can still thrive in challenging economic conditions. Diversification acts as a hedge, mitigating potential losses and benefiting from opportunities that arise during recessions.

What Stocks Perform Well During a Recession?

Defensive Stocks

Defensive stocks, such as consumer staples and healthcare stocks, tend to outperform during recessions. These industries provide essential goods and services that consumers need regardless of economic conditions. Because people need to buy basic necessities like food and health care even when facing financial constraints, companies in these industries tend to be less affected by economic downturns.

Value Stocks

Value stocks (stocks of mature companies based on fundamentals), which are generally considered undervalued relative to their intrinsic value, often outperform other growth stocks (stocks of companies with a high potential for above-average revenue and earnings growth) during recessions. This is because value stocks tend to be more attractive to investors looking for bargains. When investors look for stocks with relatively lower valuations and strong fundamentals, they may find value stocks more attractive during recessions compared to growth stocks, which often command higher valuations during periods of economic expansion.

Index funds

The benefits of investing in index funds during a recession include diversification, lower costs, and a long-term focus. Index funds provide broad market exposure and reduce the impact of any individual stock or sector that performs poorly during a downturn. Their long-term focus is consistent with the historical recovery and growth of markets over time.

Why Does the Stock Market Fall?

The stock market declines during recessionary periods due to several factors. These include:

Reduced household incomes

Recession leads to increased unemployment and a lack of business opportunities for the self-employed. Because of this, the income of households reduces; however, the expenses might not. This further leads to a reduced disposable income, which is the income left with a household after paying all expenses.

Individuals find it difficult to save and invest their limited income. As the disposable income reduces, so does the possibility of investments. This, in turn, reduces the demand for buying stocks. As demand falls, the stock market suffers a fall too.

Reduced corporate activity 

In a recession, businesses cut back on their commercial activities to cut costs. As activities are curtailed, investors become skeptical about the company’s performance and the market price of the stock may plummet. If several businesses curtail their business activities, the overall market index is adversely affected and suffers a decline.

Reduced profitability of companies 

Reduced demand, reduced business activity and a quiet economy is counterproductive to business profits. While the organization’s income declines, expenses continue. This reduces profitability. Companies with reduced profitability may attract negative market sentiment, causing their share prices to decline. If the stock prices of multiple companies fall, the overall stock market suffers.

Nil or reduced dividend income

Companies with limited or negative profits do not report dividends. Even if it does, the rate may be reduced. This further makes their stock out of favor as investors do not see the possibility of dividend income from their investment.

Now that you understand why the market goes down during a recession, it’s important to strategize accordingly to mitigate your losses. Let’s see what you can do during the recession.

What To Do in a Recession?

Although a recession can lead to a decline in the stock market, the situation is not permanent. If you are an intraday trader, you will need to watch the market carefully to find short-term trading opportunities. As the market remains highly volatile, you can profit from the sudden rise.

However, patience is key for long-term investors. You should be careful with your holdings. If you have invested in quality stocks, they will give you returns in the long run when the economy is out of recession. In the meantime, don’t panic.

Here are some more tips for stock market investors when the economy is in recession –

• If you have enough savings, invest in quality stocks when their prices are low. You can get a good amount of stock at reduced prices and then reap the returns when the stock recovers.
• Hold on to your investments. Don’t think about liquidating the portfolio. The stock market always recovers after a lull, and when it does, your portfolio can bring you attractive returns.
• Have a diversified stock portfolio. Some stocks can bring you returns even in a recession.
• You can also consider investing in a ready-made basket of securities. Teji Mandi offers two such portfolios that have delivered excellent returns over the years.
• Get expert help managing your portfolio.

How Should You Be Investing During a Recession?

A recession or the fear of one should not cause you to give up investing in the stock market. Understandably, a market downturn will tempt you to liquidate assets or exit a position in a volatile company. Still, remember a familiar saying in the investment community: timing the market beats trying to time the market. There is no way to know when is the best time to sell your stock. This is why it is important to take a long-term view when investing.