Under normal conditions, investing in the stock market can be risky. Many people try and fail to multiply their wealth. Often by taking unnecessary risks that don’t pay off. Under certain circumstances, investing in the stock market can become much scarier.
A recession is defined as a period of temporary economic decline during which trade and industrial activity are reduced. Usually identified by fall in GDP in two successive quarters.
Recessions generally occur when there is a widespread drop in spending, causing a decline in economic activity. The most recent recession was 2007, known as the great recession. The recession began on December 2007 and ended in June 2009. Making it the longest recession since World War 2.
But how do recessions affect us as investors? How can we adjust our investing habits? and most importantly, how can we benefit from recessions?
- What Causes a Recession?
- What Has Caused Previous Recessions?
- Should we be worried?
- How to Benefit From a Recession
What Causes a Recession?
There is no one right answer as to what causes a recession. It can be caused by a range of different things, often reflecting real world issues. A combination of factors can influence a recession, lets take a look at what some of these factors are.
Economic Factors:
Supply and Demand
When supply is high and demand is low, businesses lose money. Supply should be lead by demand, but when supply leads, the market can be affected.
Imagine you are an orange farmer. Every month you take your oranges to a farmers market to sell. You compete among many other farmers when selling your oranges. You still manage to produce about 100 oranges, selling them for £1 each at the farmers market.
One month, due to favourable weather, you manage to produce 200 oranges. Double your normal supply. Originally, you might think “Great, I can double my money”. But what you don’t realize is all your competition has also produced double their oranges. In order to remain competitive they start to sell their oranges cheaper in order to sell them. Driving the price of oranges down from £1. Eventually driving them down to 50 pence. Making the same amount of money as you were, but with double the effort.
While on the surface it may look like you are making the same amount. You are making less profit per orange. Harming your profitability as a business.
This shows how an increase in supply is not always a good thing. While on the surface it could be seen as beneficial, when there is more supply and less demand. Prices have to fall to remain competitive. Providing conditions that could cause a recession.
Interest Rates
High interest rates make it more expensive for consumers and businesses to borrow money, slowing down the economy.
Increasing interest rates often makes borrowing money less accessible for many people. Ending their “borrow and spend” cycle. This can mean their is less money flowing through businesses. Slowing the economy down as a result. Often not giving interest rates a chance to lower again.
This causes the economy to slide into a contraction or a recession. Causing the market to shrink. Many businesses have to lay people off due to cash flow struggles. Causing the economy to shrink further and further until interest rates are reduced to resolve the issue.
Structural Shifts
Changes in industries are just as likely to cause recessions. For example, consider a sudden increase in the cost of oil.
Oil is a crucial input for many industries, meaning that when the price rises. So do production and transportation costs for many industries. When an industries costs increase, they often pass this on to consumers by raising prices or lowering what they offer.
With increased costs business profits plummet, ultimately impacting economic growth and inflation levels. Layoffs can follow in an attempt to reduce operating costs. Providing the key components for a recession.
Psychological Factors:
Many psychological factors can affect the market at the same time. Being just as important, or more so than economic factors.
Consumer Confidence
Consumers drive the economy, spending money allows for government funding in the form of tax. It allows for businesses to grow, hire employees, who then spend more money. Continuing the cycle and allowing for the constant growth of the economy.
When consumer confidence drops however, this spending is reduced creating a negative impact on the economy. This impact can slow down the growth of the economy, or even reverse it. Creating a recession.
Consumer confidence can be influenced by several factors. Such as unemployment rates, inflation and house and living costs. These are often tied to economic factors. Showing how many factors can link together. Often building into a recession slowly.
What Has Caused Previous Recessions?
While there are many factors that can cause a recession, real world events heavily influence when a recession occurs. To understand what could cause recessions in the future, we need to understand what has caused recessions in the past.
The COVID-19 Recession
February 2020 – April 2020
While not technically a recession due to it’s short duration. It is a great example of what can cause a recession. It is an example that everyone remembers. The COVID-19 pandemic resulted in travel and work restrictions. Causing employment levels to plummet due to many businesses having to close during the pandemic. In turn, the economy suffered, causing a massive financial downturn. Causing the market to fall between 12% and 13% in most global stock markets.
The Great Recession
December 2007 – June 2009
The great recession was caused by the downturn of housing prices in the US. In turn triggering a global financial crisis. Famous index, the S&P 500 fell by up to 57% at its lowest. Causing the worst economic downturn since 1937-1938. Caused by unscrupulous mortgage underwriting practices, there was a massive housing market bubble. Which eventually popped, causing housing prices to crash.
The oil industry also suffered, peaking to highs in mid 2008 before crashing. Leading to a deflation that strained the U.S economy. GDP declined by 4.3% with unemployment highs of up to 9.5%.
The Dot-Bomb Recession
March 2001 – November 2001
The dot-bomb recession was caused by yet another bubble. The dotcom bubble was caused by investors being overly optimistic about the future of internet companies. Investors were willing to lend money to companies with no chance of making a profit. Overtaken by the hype of the media, investors skipped proper assessment of these companies.
Eventually the federal reserve increased interest rates to reduce investment capital, causing investors to panic and sell dot-com stocks. Causing a GDP decline of 0.3%, with unemployment peaking at 5.5%.
The Gulf War Recession
July 1990 – March 1991
Another mild recession, beginning a month before Iraq invaded Kuwait. Causing a spike to the prices of oil. Eventually this lead to the intervention of the US military in order to calm the oil market. This lead to increased operating costs for many businesses. Market instability, leading to a contraction of the economy.
There was a GDP decline of 1.5% and unemployment peaked at 6.8%.
Should we be worried?
No, we shouldn’t be worried. Although recessions can be scary as we are going through them. Given time the economy always recovers. One of the most damaging things we can do during a recession as investors can be to panic. Selling our assets at lower prices and failing to turn a profit during a recession can make us lose profit. While it may take some time. The best thing to do can be to wait out the recession. Ensure you have enough cash to cover your expenses and leave your assets to recover. Or as we are about to cover, grow your portfolio.
In addition to this, recessions are becoming less common. Recent decades show a trend towards fewer and shorter recessions. Due to improved economic policies and a better understanding of how to manage economic cycles. However, they still remain a recurring feature of the economic landscape. But this is okay, we just need to understand how to survive them.
How to Benefit From a Recession
Now we know what causes a recession, we need to know how to survive it and even benefit from it. When there are economic downturns and the market declines, share prices in many companies become cheaper. Imagine a fire sale where almost everything you could possibly want is on offer.
When a recession strikes many inexperienced investors sell their assets. This is known as panic or fear selling. The threat of declining stock prices causes them to panic and sell, withdrawing their cash. Experienced investors opt to buy more. By purchasing a stock at a reduced price, you are opening the potential for massive growth. After the recession ends, depending on the stock. Share price is likely to increase back to pre-recession levels, if not more.
It is important to choose companies with strong fundamentals that can weather the recession period. Making sure the stock you have bought will still exist after the recession is massively important. If this is of particular concern, an index fund such as the S&P 500 could also be purchased. When the market recovers, so will the index fund.
Investing in sectors that are consumer staples such as food and healthcare can provide a more stable investment during recessions. People still require the essentials regardless of economic conditions. While stocks that represent luxury products or services may suffer more during the recession.
As always, during a recession diversification of your portfolio is particularly important. It is also particularly important to only invest what you can afford to lose. It is worth noting that recessions can be particularly hard times financially. It is important to keep enough cash to cover expenses. Ensuring you will not have to sell assets at a bad time.
Finally it is worth remembering that the economy always recovers. Over history while the situation may seem dire while in a recession. The economy always recovers to well above pre-recession levels. So remember, don’t panic sell your investments, grab some bargains and keep enough cash to cover your expenses.
If you follow these rules you won’t just be surviving a recession, but you’ll be making the most of a rare and valuable opportunity!
Effortless Investing 
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