Trading stocks during a recession: What you need to know
By Jenal Mehta
Updated
Although the global economy is not currently in recession, financial markets worldwide have been showing signs of its approach.
A recession generally implies that equity markets are in decline, and is accompanied by increased volatility. There are, however, ways in which investors can win during a recession.
A big part of that is understanding how the market behaves.
S&P 500 (US500) Price Chart
One key trend that investors could look at is that broader markets, as measured by indexes such as the S&P 500 (US500) and FTSE 100 (UK100), tend to fall much more sharply prior to a recession than within the recession period itself.
Defensive sectors such as utilities and consumer staples tend to outperform at such times, while technology and financials do not fare as well.
Investors also need to pay attention to economic policies, to gather intel on how long a recession may last.
What is your sentiment on US500?
How do you know a recession has started?
Recession does not have an official definition, but it is most widely believed that a prolonged decline in real gross domestic product (GDP) means an economy is in recession. Most analysts and economists need this trend to occur for at least two consecutive quarters before they call a recession.
We are currently not in a recession. However, there are indications that we might be close to one.
Piero Cingari, an analyst at Capital.com, said: “Europe may face a recession sooner than the US due to the negative impacts of the Russian-Ukraine conflict. However, if the Federal Reserve is forced to boost rates quicker than expected in order to combat inflation, this might accelerate the risk of entering a recession for the US.”
Like any economic cycle, of course, recession is not permanent. For investors, estimating the length of a recession may be an useful tool in planning their investments. Cingari commented on the different variables to watch out for
“Many variables affect the length of a recession, but the most crucial is inflation. If a potential recession coincides with a drop in inflation, governments and central banks may be able to respond by raising stimulus, thereby boosting the economy’s quick recovery.
“However, if inflation stays high even in the event of an upcoming recession, ie a stagflationary condition, then central banks won’t have the luxury of promoting interest rate cuts, therefore prolonging the recession,” he said.
FTSE 100 (UK100) Price Chart
How do equity markets behave?
The behaviour of equities varies, depending on the type of sector and the particular period of recession. Markets of course decline during a recession, as measured via indexes such as FTSE 100 (UK100) and S&P 500 (US500).
However, research and analysis carried out by Darrow Wealth Management has shown that in the periods leading up to historic recessions, the markets declined much more sharply than during the recession itself.
When measuring recessions since 1953 they found that, on average, the S&P 500 (US500) lowered 1% during recessions, while in the six months before that the index dropped 2%, and in the 12 months prior to recession it dropped by 3%.
Which sectors outperform during a recession?
Within equity markets, the behaviour of different sectors varies.
Cingari spoke about which sectors tend to outperform, saying “in a recession, consumer staples and utilities often fare well.”
Defensive sectors such as consumer staples and utilities, as well as telecommunications and healthcare, tend to outperform during this period as consumers do not cease spending on these necessary items. Thus, these companies can protect their profitability, and so the value of these sectors tends to decline less than others.
Cingari explains: “People cut back on leisure and put off buying a new car when they wish to save more money and limit their budgets. They do, however, keep paying their bills and continue drinking Coca-Cola (KO)”
As for poorly performing industries, Cingari says the recovery period of these sectors depends on what economic policies are in place.
“If rate cuts and fiscal stimulus are implemented, sectors that have performed poorly, such as technology and cyclical goods, will swiftly rebound. However, if stagflation is a possibility, the recovery of the most affected industries might take considerably longer than expected.”
Many investors also head for safe havens during a recession.
How can investors make the most of this?
There are many potential options for investors to make the most of a recessive market.
Depending on how long the recession lasts for, there several different strategies investors could follow.
- Go short: the short-term investor can make most of the recessive market by selling forward. With research, the investor can make the most of the sharp decline, especially of those sectors which are expected to underperform, such as technology and real estate.
- Make a post-recession plan: the market will not stay this way for long, so looking at strategies to make the most of market growth post-recession is also a consideration.
- Hedge: an investor can use both long and short positions to navigate the market. The investor also has options to hedge using positions in two different equity sectors.
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