💾 Archived View for gmi.noulin.net › mobileNews › 3899.gmi captured on 2021-12-05 at 23:47:19. Gemini links have been rewritten to link to archived content
⬅️ Previous capture (2021-12-03)
-=-=-=-=-=-=-
February 05 2011 | Filed Under Bonds , Commodities , Economics , Stocks
While it would be Utopian to have the economy grow at a stable rate, economic
recessions are a fact of life and are as unavoidable as the setting of the sun.
The economy has a cycle that involves both periods of growth and expansion, and
periods of decline and recession.
For investors, it's often the recessionary cycle that causes the most concern.
In this article, we will look at how to properly invest as the economy moves
through this phase.
Tutorial: Economics Basics
What Is a Recession?
A recession can be defined as an extended period of significant decline in
economic activity including negative gross domestic product (GDP) growth,
faltering confidence on the part of consumers and businesses, weakening
employment, falling real incomes, and weakening sales and production. This is
not exactly the environment that would lead to higher stock prices or a sunny
outlook on stocks.
Other aspects of recessionary environments as they relate to investments
include a heightened risk aversion on the part of investors and a subsequent
flight to safety. However, on the bright side, recessions do eventually lead to
recoveries and follow a relatively predictable pattern of behavior along the
way. (To read more about this, check out Recession: What Does It Mean To
Investors?)
Keep an Eye on the Horizon
The real key to investing before, during and after a recession is to keep an
eye on the big picture, as opposed to trying to time your way in and out of
various market sectors, niches and individual stocks. Even though there is a
lot of historical evidence of the cyclicality of certain investments throughout
recessions, the fact of the matter is that this sort of investment acumen is
beyond the scope of the ordinary investor. That said, there's no need to be
discouraged because there are many ways an ordinary person can invest to
protect and profit during these economic cycles. (To learn more about investing
in cycles, read Understanding Cycles - The Key To Market Timing.)
To begin with, consider the macroeconomic issues of a recession and how they
affect capital markets. When a recession hits, companies slow down business
investment, consumers slow down their spending, and people's perceptions shift
from being optimistic and expecting a continuation of recent good times to
becoming pessimistic and uncertain about the future. As such, people get
understandably frightened, become worried about prospective investment returns
and rationally scale back risk in their portfolios. The results of these
psychological factors manifest themselves in a few broad capital market trends.
Within equity markets, the results are pretty obvious. As people become
uncertain about prospective earnings, they perceive a greater amount of risk in
their investments, which broadly leads investors to require a higher potential
rate of return for holding equities. Of course, for expected returns to go
higher, current prices need to drop, which occurs as investors sell their
higher risk investments and move into safer securities including government
debt. This is why equity markets tend to fall, often precipitously, prior to
recessions as investors shift their investments.
Recessions and Specific Investments
In fact, history shows us that equity markets have an uncanny ability to serve
as a leading indicator for recessions. For example, the markets started a steep
decline in mid-2000 before the economic recessionary period between March 2001
and November 2001. But even in a decline there is good news for investors:
there are pockets of relative outperformance to be found in equity markets.
Investing in Stocks in a Recession
When investing in stocks during recessionary periods, the relatively safest
places to invest are in high-quality companies with long business histories, as
these should be companies that can handle prolonged periods of weakness in the
market.
For example, companies with strong balance sheets, including those with little
debt and strong cash flows, tend to do much better than companies with
significant operating leverage (or debt) and poor cash flows. A company with a
strong balance sheet/cash flow is better able to handle an economic downturn
and should still be able to fund its operations as it moves through the weak
economic times. In contrast, a company with a lot of debt may be damaged if it
can't handle its debt payments and the costs associated with its continuing
operations. (To learn how to read these documents, see What Is A Cash Flow
Statement? and Breaking Down The Balance Sheet.)
Also, traditionally, one of the safe places in the equity market is consumer
staples. These are typically the last products to be removed from a budget. In
contrast, electronic retailers and other consumer discretionary companies can
suffer as consumers hold off on these higher end purchases. (To learn more,
read Cyclical Versus Non-Cyclical Stocks.)
Investing in Fixed Income in a Recession
Fixed-income markets are no exception to this line of reasoning. Again, as
investors become more concerned about risk, they tend to shy away from it.
Practically speaking, this means investors steer clear of credit risk, meaning
all corporate bonds (especially high-yield bond) and mortgage-backed securities
because these investments have higher default rates than government securities.
Again, as the economy weakens, businesses have a more difficult time generating
revenues and earnings, which can make debt repayment more difficult and could
lead to bankruptcy as a worst-case scenario.
Moreover, as investors sell these assets, they seek safety and move into U.S.
Treasury bonds. In other words, the prices of risky bonds go down as people
sell (or the yields increase) and the prices on Treasury bonds go up (or the
yields decrease). (For more insight, see What are the risks of investing in a
bond?)
Investing in Commodities in a Recession
Another area of investing you may want to consider in the context of a
recession is commodity markets. The general rule to understand about these
investments is to keep in mind that growing economies need inputs, or natural
resources. As economies grow, the need for natural resources grows, and the
prices for those resources rise.
Conversely, as economies slow, demand slows and prices go down. So, if
investors believe a recession is forthcoming, they will sell commodities,
driving prices lower. However, commodities are traded on a global basis, and
U.S. economic activity is not the sole driver of demand for resources such as
oil, gas and steel, so don't necessarily expect a recession in the U.S. to have
a direct impact on commodity prices, at least not as strong of an effect as we
have seen in the past. At some point in time, the world's various economies
will separate from the U.S., creating a demand for resources that is
increasingly less sensitive to U.S. growth in GDP.
If you expect a recession, positioning your portfolio is quite simple. Shift
assets away from equities, especially the riskiest equities like small stocks.
You should also move away from credit risk in fixed-income markets and into
Treasuries.
Investments and Recovery
So, what to do during a recovery? It sounds too simple, but investing for an
economic recovery entails doing the exact opposite of what was described
earlier.
Why?
Again, keep an eye on the macroeconomic factors. For example, one of the most
often used tools the government uses to reduce the impact of a recession is
monetary policy that leads to a reduction in interest rates with the purpose of
increasing the money supply, discouraging people from saving and encouraging
spending. This helps to increase economic activity.
One of the side effects of low interest rates is that they tend to create
demand for higher return, higher risk investments. So, as recessionary
expectations bottom out, pessimism fades away and optimism works its way back
into people's minds. Moreover, investors re-examine opportunities for riskier
investments in the context of what is usually a low interest rate environment.
They also embrace risk.
As a result, equity markets tend to do very well during economic recovery.
Within equity markets, some of the best performing stocks are those that use
operating leverage as part of their ongoing business activities, especially as
these are often extremely undervalued after being beat up during the market
downturn. Remember, leverage works great during good times, and these firms
tend to grow earning faster than companies without leverage, but they also face
real risks during weakening times. Moreover, growth stocks and small stocks
tend to do well as investors embrace risk during an economic recovery. (To
learn more about operating leverage, read Operating Leverage Captures
Relationships.)
Similarly, within fixed-income markets, increased demand for risk manifests
itself in a higher demand for credit risk, meaning the corporate debt of all
grades and mortgage-backed debt tends to attract investors, driving prices up
and yields down. Logically, U.S. Treasuries tend to go down in value as
investors shift out of these assets and yields go back up.
The same logic holds for commodity markets in that faster economic growth means
higher demand for materials, driving prices up. However, remember that
commodities are traded on a global basis, and U.S. economic activity is not the
sole driver of demand for resources.
Will the Sun Come Out Tomorrow?
To conclude, the best advice to investing during recessionary environments is
to focus on the horizon and manage your exposures. It is important to minimize
the risk in your portfolio and maintain your capital to invest in the recovery.
Of course, you're never going to time the beginning or end of a recession to
the day or the quarter, but seeing a recession far enough in advance isn't as
hard as you might think. The real trick here is to simply have the discipline
to step away from the crowd and shift away from risky, high-returning
investments during times of extreme optimism, wait out the oncoming storm, and
have an equal discipline to embrace risk at a time when people are shying away
from it to get ahead of the cycle.
To keep reading about market recessions, check out Panic Selling - Capitulation
Or Crash? and The Greatest Market Crashes.
by Eric Petroff