Introduction to Recessions
There’s a common joke in economic circles that a recession is when your neighbor loses their job, and a depression is when you lose yours. However, the National Bureau of Economic Research (NBER) defines a recession as a "significant decline in economic activity that is spread across the economy and that lasts more than a few months." If a recession is particularly severe and/or long-lasting, the NBER will call it a depression.
Understanding Recessions
It’s often thought that two quarters of declining gross domestic product (GDP) is all you need to define a recession. However, the truth is more complicated. For instance, GDP declined in the first two quarters of 2022, but a recession wasn’t declared. To be official, a recession has to include a downward trend in GDP characterized by a decline in production and employment, which in turn causes the incomes and spending of households to decline. These income and spending declines could lead to further declines in production and employment in a vicious cycle that morphs into a depression.
The Impact of Recessions
In a severe recession—or depression—unemployment spikes to double-digit levels, stocks fall 40% or more, real estate prices crash, major companies declare bankruptcy, and governments go deeply into debt helping struggling companies and households. The impact of a severe recession can take years to overcome. As we learned from the Great Depression, entire generations of people with the bad luck to enter the workforce during such times may never make up the lost income opportunities. Those who retire into the teeth of a recession often find a huge chunk of their savings is gone, forcing them to either live on less than they’d expected or to reenter the workforce.
Signs of a Looming Recession
There are some clues that might help you get a sense of when economic misery may be on the horizon. These include:
- Job cuts: Although companies lay off workers even during boom times, the layoffs come much more often when corporate leaders start to feel squeezed.
- Earnings weakness: Wall Street analysts and companies project earnings per share by quarter and over the course of the coming year. These estimates rise and fall based partly on economic winds, so when you see them fall steadily, it’s often a sign that all may not be well.
- Weak Federal Reserve data: Keep a close eye on the Fed’s regular reports on regional trends, which can sometimes point to softness in the economy.
- Declining manufacturing trends: When people start feeling the pinch of a worsening economy, they often pull back on spending. One of the first data points that picks this up is monthly manufacturing data from the Institute of Supply Management (ISM).
Recessions and Long-Term Investing
Any long-term investor will likely face several economic recessions over decades of investing. They’re unavoidable and outside your control. The way you respond, however, is in your control, especially when it comes to the emotional side of investing. Often the first sign of a recession is a collapse in stock prices. It’s easy to get caught up in anxiety at moments like these, and there are definitely times when taking some money off the table makes sense. However, if you’re in the market for the long term, remind yourself that these drastic dives happened decade after decade over the last 100 years, but the overall direction of stocks remained higher throughout.
Staying Calm During a Recession
Typically, people who completely exited stocks during a recession came to regret it. The 2008 and 2020 recession sell-offs were followed by long rallies that quickly brought major indexes back above pre-recession levels. That may not always be the case, because past performance doesn’t guarantee anything about the future. Also, the recovery time can vary. The 2008 and 2020 comebacks were helped a great deal by the Federal Reserve’s zero interest rate policy paired with stimulus checks, tax credits, unemployment benefit extensions, and other government aid.
Conclusion
If you believe in the power of capitalism, human ingenuity, and the ability of central banks to smooth out economic extremes, it’s hard to justify throwing up your hands and giving in when recession takes the market lower. Instead, consider your asset allocations and which sectors you have exposure to. Certain sectors tend to perform better than others during recessions, and bonds and other fixed-income securities can sometimes be a line of defense. Also, when markets are in panic mode, growth highfliers and even quality cash cows can sometimes become bargains worthy of a spot in your portfolio. Keep a wish list of stocks you’d like to add—if the price is right—and wait for your opportunity. As legendary investor Warren Buffett once said, "Be fearful when others are greedy and greedy only when others are fearful."
