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March 19 2010 | Filed Under Bonds , Economics , Retirement , Short Selling
When the economy heads into a tailspin, you may hear news reports of dropping
housing starts, increased jobless claims and shrinking economic output. How
does this affect us as investors? What do house building and shrinking output
have to do with your portfolio? As you'll discover, these indicators are part
of a larger picture, which determines the strength of the economy and whether
we are in a period of recession or expansion. (For some background reading,
check out: A Review Of Past Recessions.)
The Phases of the Business Cycle
In order to determine the current state of the economy, we first need to take a
good look at the business cycle as a whole. Generally, the business cycle is
made up of four different periods of activity extended over several years.
These phases can differ substantially in duration, but are all closely
intertwined in the overall economy.
Peak - This is not the beginning of the business cycle, but this is where we'll
start. At its peak, the economy is running at full steam. Employment is at or
near maximum levels, gross domestic product (GDP) output is at its upper limit
(implying that there is very little waste occurring) and income levels are
increasing. In this period, prices tend to increase due to inflation; however,
most businesses and investors are having an enjoyable and prosperous time.
Recession - The old adage "what goes up must come down" applies perfectly here.
After experiencing a great deal of growth and success, income and employment
begin to decline. As our wages and the prices of goods in the economy are
inflexible to change, they will most likely remain near the same level as in
the peak period unless the recession is prolonged. The result of these factors
is negative growth in the economy.
Trough - Also sometimes referred to as a depression, depending upon the
duration of the trough, this is the section of the business cycle when output
and employment bottom out and remain in waiting for the next phase of the cycle
to begin.
Expansion/Recovery - In a recovery, the economy is growing once again and
moving away from the bottoms experienced at the trough. Employment, production
and income all undergo a period of growth and the overall economic climate is
good.
Notice in the above diagram that the peak and trough are merely flat points on
the business cycle at which there is no movement. They represent the maximum
and minimum levels of economic strength. Recession and recovery are the areas
of the business cycle that are more important to investors because they tell us
the direction of the economy.
To further complicate matters, not all business cycles go through these four
steps sequentially. For instance, during a double dip recession, the economy
goes through a recession followed by a short recovery and another recession
without ever peaking. (Not everyone hurts during a recession. Learn more in
Industries That Thrive On Recession.)
Recession Versus Expansion
Recession is loosely defined as two consecutive quarters of decline in GDP
output. This definition can lead to situations where there are frequent
switches between a recession and expansion and, as such, many different
variations of this principle have been used in the hope of creating a universal
method for calculation.
The National Bureau of Economic Research (NBER) is an organization that is seen
as having the final word in determining whether the United States is in
recession. It has a more extensive definition of recession, which deems the
following four main factors as the most important for determining the state of
the economy:
Employment
Personal income
Sales volume in manufacturing and retail sectors
Industrial production.
By looking at these four indicators, economists at the NBER hope to gauge the
overall health of the market and decide whether the economy is in recession or
expansion.
The tricky part about trying to determine the state of the economy is that most
indicators are either lagging or coincidental rather than leading. When an
indicator is "lagging" it means that the indicator changes only after the fact.
That is, a lagging indicator can confirm that an economy is in recession, but
it doesn't help much in predicting what will happen in the future. (Learn more
about this in Economic Indicators To Know.)
What Does this Mean for Investors?
Understanding the business cycle doesn't matter much unless it improves
portfolio returns. What's an investor to do during recession? Unfortunately,
there is no easy answer. It really depends on your situation and what type of
investor you are. (For some ideas, see Recession-Proof Your Portfolio.)
First, remember that a bear market does not mean there are no ways to make
money. Some investors take advantage of falling markets by short selling
stocks. Essentially, an investor who sells short profits when a stock declines
in value. Problem is, this technique has many unique pitfalls and should be
used only by more experienced investors. (If you want to learn more, see the
tutorial Short Selling.)
Another breed of investor uses recession much like a sale at the local
department store. Referred to as value investing, this technique involves
looking at a fallen stock not as a failure, but as a bargain waiting to be
scooped up. Knowing that better times will eventually return in the economy,
value investors use bear markets as buying sprees, picking up high-quality
companies that are selling for cheap.
There is yet another type of investor who barely flinches during recession. A
follower of the long-term, buy-and-hold strategy knows that short-term problems
will barely be a blip on the chart when taking a 20-30 year horizon. This
investor merely continues dollar-cost averaging in a bad market the same way as
he or she would in a good one.
Of course, many of us don't have the luxury of a 20-year horizon. At the same
time, many investors don't have the stomach for riskier techniques like short
selling or the time to analyze stocks like a value investor does. The key is to
understand your situation and then pick a style that works for you. For
example, if you are close to retirement, the long-term approach definitely is
not for you. Instead of being at the mercy of the stock market, diversify into
other assets such as bonds, the money market, real estate, etc.
Conclusion
The financial media often takes on a "sky is falling" mentality when it comes
to recession. But the bottom line is that recession is a normal part of the
business cycle. We can't say what the best course is for you - that's a
personal decision. However, understanding both the business cycle and your
individual investment style is key to surviving a recession. (For further
reading, check out The Impact Of Recession On Businesses and Profiting In A
Post-Recession Economy.)