Reviewed by Ebony Howard
Economic cycles include periods of growth and decline, and while downturns don’t last nearly as long as expansions on average they can be especially costly for investors. From 1928 to 2023, the S&P 500 has had 18 strong corrections with downturns ranging from 10% to 20%, with corrections having an average loss of 13.4%. Luckily, there are strategies available to limit portfolio losses and even log some gains during a recession.
Key Takeaways
- A recession is a significant, widespread, and extended decline in economic activity.
- Riskier assets like stocks and high-yield bonds tend to lose value in a recession, while gold and U.S. Treasuries appreciate.
- Shares of large companies with ample, steady cash flows and dividends tend to outperform economically sensitive stocks in downturns.
- Investors can’t hope to time a recession reliably, but diversification and measured steps to control risk can help preserve capital and position portfolios to profit from a recovery.
What Is a Recession?
A recession is a significant and widespread decline in economic activity typically lasting more than a few months. It is often defined in the media as two consecutive quarters of negative gross domestic product (GDP) growth. GDP is a measure of all goods and services produced in a country.
Recession symptoms include faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and declining sales and production—not exactly the environment that tends to lead to investor confidence and higher stock prices. In fact, recessions increase investors’ risk aversion.
Note
The National Bureau of Economic Research dates recessions from the peak of the prior economic expansion to the trough of the economic decline. By that definition, recessions end at the very outset of a recovery,
Can the Stock Market Predict a Recession?
Economist Paul Samuelson famously quipped that the stock market has predicted nine of the last five recessions. That was in 1966, and 50 years later the stock market’s record as a recession signal remained comparable.
Bear markets associated with recessions tend to start and trough before economic activity does and to last longer than other bear markets.
But of course, there’s no way of knowing ahead of, or in the middle of, a stock decline how deep or long-lasting it might prove. An inverted yield curve has historically been the most reliable recession indicator, though hardly an infallible one.
Overreacting to any recession signal could be costly: economic expansions often last longer than many expect, and deliver some of the strongest stock-market gains near the end.
How Asset Classes Perform in Recessions
Recall that recessions are relatively rare but expose economies and portfolios to the possibility of rapid declines, leading to growing risk aversion among investors and companies. As risk premia—the excess returns investors require over risk-free assets—rises, the prices of risk assets decline accordingly. As you would expect, the asset classes with returns less reliant on economic growth tend to outperform.
Gold and bonds, U.S. government as well as investment-grade corporates, have historically fared best during recessions, while high-yield bonds and commodities have traditionally suffered alongside stocks.
Experienced investors know they are unlikely to predict a recession in time to flee risk assets for safe harbors. A diversified portfolio stands an excellent chance of recouping losses sustained in a recession during the subsequent recovery.
Stock Picking During Recessions
The safest stocks to own in a recession are those of large, reliably profitable companies with a long track record of weathering downturns and bear markets. Companies with strong balance sheets and healthy cash flows tend to fare much better in a recession than those carrying heavy debt or facing big declines in the demand for their products.
Historically, the consumer staples sector has outperformed during recessions, because it supplies products that consumers tend to buy regardless of economic conditions or their financial situation. Consumer staples include food, beverages, household goods, alcohol, tobacco, and toiletries.
In contrast, appliance retailers, automakers, and technology suppliers can suffer as consumers and companies cut spending.
Investing for Recovery
Recessions are relatively rare events, and countries have fiscal and monetary policy tools that promote recoveries. Once the imbalances that led to the recession are corrected, economies tend to rebound even in the absence of policy support.
As recovery takes hold, recession risk factors such as high operating leverage and dependence on economic momentum can turn into advantages for growth and small-cap stocks that may have become undervalued in the meantime.
In fixed-income markets, increased demand for risk makes corporate debt of all grades and mortgage-backed securities relatively more attractive. As risk premium declines, so do the yield spreads for such debt over U.S. Treasuries with a similar maturity. Government bonds tend to decline, pushing yields up. That means riskier debt could still lose value in absolute terms even if it outperforms Treasuries.
A return to growth also tends to be good news for commodities, since higher economic activity boosts demand for raw materials. Remember, however, that commodities are traded on a global basis—the U.S. economy isn’t the sole driver of demand for these resources.
Is It Good to Invest in a Recession?
Yes, it can be a good opportunity to invest in a recession if done carefully and wisely. In a recession, stocks tend to drop in value, even of good companies, which presents a buying opportunity for smart investors as they will benefit when the prices eventually go up. If investors focus on financially stable companies and diversify risk, as well as set aside an emergency fund and avoid leverage, a recession can be a good time to invest money.
Where Should You Put Money in a Recession?
In a recession, it’s smart to preserve your capital by investing in safer assets, such as bonds, particularly government bonds, which can perform well during economic downturns. Putting your money in defensive stock sectors, such as utilities, consumer staples, and healthcare can also be a good strategy as these goods and services are essential regardless of the economic climate. Additionally, keeping cash reserves in the bank or high-yield savings accounts for liquidity is also good for emergencies or buying opportunities if the market dips further.
What Should I Not Invest in During a Recession?
During a recession, it is wise not to invest in high-risk assets, such as small-cap stocks, cryptocurrencies, and overly leveraged companies. These assets are already volatile and risky during good times and will be more so during economic downturns. Companies in the luxury sector and non-essential goods and services sector should also be avoided as they will struggle when consumer spending decreases during tough times and money is spent on essential goods and services.
The Bottom Line
When recessions strike, it’s best to focus on the long-term horizon and manage your exposures, limiting risk and setting aside capital to invest during the recovery.
While no investor can hope to reliably time the onset of a recession or should respond by fleeing risk assets entirely, prudent diversification ahead of time can preserve capital and position you to profit from a recovery.