If you’ve been following the financial press this year, you have no doubt heard the chatter that the world economy is likely heading into a recession in the coming months. It can be a little scary since nobody likes uncertainty around their finances, but the truth is that recessions are part of the normal ups and downs of economies around the world.
A recession can also be an ideal time to start trading and investing in certain assets. Not only do stock markets generally decline during recessions, giving short-term traders a chance to short the market, but also long-term investors a chance to buy at lower prices, but other assets such as forex, commodities and even crypto can act in predictable ways that give knowledgeable traders an opportunity to earn profit.
It’s helpful to have a working definition of a recession, and getting one is not as easy as it may sound. A common definition is that a country is in recession when it suffers two consecutive quarters of negative Gross Domestic Product (GDP) growth. A country’s GDP is the sum of all the goods and services produced, and GDP data is announced as a year-on-year (YoY) percentage change. If a country’s GDP shrinks for two consecutive quarters, many economists consider that country to be in a recession.
However, at this time (August 2022), that definition may not be quite appropriate. We are just coming out of a once in a century pandemic which caused massive disruption to almost every industry and every business on the planet for the last two years. Many factories, and even whole industries in many cases, were completely shut down for an extended period.
For example, the US has recorded negative GDP growth in both Q1 and Q2 this year, but the US authorities are denying the US is in recession, citing the robust employment data as a sign that GDP data alone cannot be used to define a recession.
So, while the traditionally accepted recession definition of two consecutive quarters of negative GDP growth has been satisfied (in US at least), in this case we may look to define a recession (rather more subjectively) as “less than ideal economic conditions”. In any case, when economies start to struggle, financial markets can become more volatile, and this volatility can present opportunities for profit.
If you are investing in the stock market, you should certainly be concerned about the effect of a recession on your portfolio. Much of a country’s GDP is produced by publicly traded companies, so if the overall production is decreasing, many of these companies will be earning lower profits.
Stock markets tend to decline during a recession, with some sectors and stocks being hit harder than others, although there may also be some stocks that do rather well during a recession.
It should be noted, however, that while recessions cause declines in the overall stock market, recessions don’t last forever, so if you are invested on a longer time horizon, say longer three years or more, simply waiting out the recession can be a perfectly acceptable strategy.
The price of a stock is based on the perceived value of the company, based on its current earnings as well as the market’s expectations for the future earnings. Current perceived value is calculated using the Price to Earnings Ratio or P/E Ratio. The total value of a company is calculated by multiplying the total number of outstanding shares by the current share price. If you divide this total value of the company (Price) by its total annual earnings (Earnings), you get the P/E Ratio.
Different sectors (Energy, Financial, Technology, Healthcare, etc.) have different P/E ratios, usually between 10 to 25 times earnings, depending on the market’s perception of each sector.
During a recession, not only do the earnings of most companies decline, but the market perception for future earnings will also decline. Therefore, the stock price will fall, but also the P/E ratios may also fall (indicating this less optimistic future earnings expectations). A falling P/E ratio is a phenomenon known as “multiple compression”.
So why aren’t investors willing to pay the same P/E for a stock? One huge contributor to this current (potential) recession is inflation. Reserve Banks around the globe have set interest rates at historic lows to stimulate their economies during/after Covid. In addition, governments (via their central banks) have handed out enormous amounts of money during the pandemic to meet critical needs such as food and housing.
There is now a perfect storm of ingredients for high global inflation:
Inflation has the effect of lowering the P/E ratio that the market is willing to pay for a stock. For example, a company may be projected to earn $10 per share in the next three years. If inflation sets in, even if that company is still able to grow to the point it can earn that $10 per share in the future, that $10 is now worth less than it would have been had we not had such high inflation. Hence, inflation and the fear of continued high inflation are what is causing the multiple compression.
So now we see both components, the earnings, and the P/E ratio, of a company’s stock price are decreasing. The result will be that many stocks see a significant decline in their stock price, although it should be noted that the S&P has already officially touched bear market territory (down 20% from its high) in June 2022. The question now is whether the stock market will fall further in the coming months, and if so, how far?
Just because we are in a recession does not mean you must resign yourself to losing money in the stock market. In fact, it may be an opportunity to make significant profits.
There are several ways to manage a stock portfolio during a recession, and as we have already discussed, simply waiting it out is a perfectly acceptable solution for longer-term investors, since history tells us that stock markets continue to hit new highs in the long run.
One other strategy that works well in recessions is called Dollar Cost Averaging. If you are saving for retirement, Dollar Cost Averaging is simply putting a set amount of money into your savings or stock portfolio on a regular basis without regard to what the stock market is doing. You may be putting 10% of your income into a retirement account every month, and that does not change if the market happens to be up or down, you simply automate the process.
Dollar Cost Averaging works well in a recession because your money will be used to buy stocks at lower prices when the market is going down. This strategy will always work, because as we know from history, the stock market always increases given a long enough time frame.
If you really want to take advantage of the recession, this may be a time to increase the amount you’re investing at cheaper prices. After all, the best way to make money is to buy low and sell high. In a recession, stocks are low, therefore this is without question a good time to accumulate shares.
If you are the type of person to panic when you see your portfolio drop the day after a stock purchase (and that is over half the population), don’t worry! You can either commit a smaller amount of your income to invest, or simply not invest at all. As we have seen time and time again, low stress Dollar Cost Averaging is guaranteed to succeed.
However, if you have the stomach for more aggressive investments, now could be the time to really make some money.
So far, we’ve been talking about longer-term investing, holding stocks for months, years or even decades, but significant profits can also be made during a recession by short-term trading, holding positions for minutes, hours, days or maybe weeks.
Also, online trading platforms enable you to “sell short”, effectively selling an asset you don’t own at a high price, aiming to buy it back later at a low price if the price declines. In this way, you can make money from falling markets as well as rising markets.
There is also a wide range of assets that can be traded, from forex and commodities to equities and cryptocurrencies. However, this shorter-term trading does involve more day-to-day involvement from you since you may be making a few trading decisions each week. The advantage, of course, is that you can step away from the market and take a break from trading whenever you want, without any leaving risk on the table.
Your decisions to buy or sell any assets can be based on fundamental analysis or (more often) charts and technical analysis. Using charts, it is also easy to set stop losses and take profit targets to enable you to accurately manage your risk at all times.
Many investors buy commodities such as gold and silver as a hedge against an economic downturn. Recessions often see these types of assets increase in value and having the foresight to purchase these assets before a recession starts to bite can result in a nice profit.
Conversely, commodities that are used in construction, such as copper, often fall dramatically in a recession as major construction and infrastructure projects come to a halt. If you are interested in trading commodities, this potential downturn will provide a great opportunity to sell short copper and similar assets with the expectation of being able to buy them back much cheaper later.
Forex traders also stand to profit in a recession. Understanding what drives price change in foreign currencies can make trading simple. Countries with a high export rate, such as Japan, will see demand for their products fall. Less demand for Japanese cars and electronics means less demand for Yen to buy them, meaning the Yen will lose value compared to importing countries such as the USA and UK.
The recession will not hit all stocks the same. Some businesses will be hit much harder, and some may actually thrive in a recession. Think about how you spend your money when money gets tight. Do you cut back on everything? Probably not.
You may not buy a new car or go on a nice vacation if you had less disposable income, but you’re unlikely to cut back on things like shampoo or toothpaste. There are some types of businesses that can thrive in recessions. People must eat, and it is likely that less people will be going to expensive restaurants during a recession, but they will replace their weekly high end luxury restaurant meal with a cheaper alternative. Therefore packaged food companies will likely see an increase in sales during a recession, so it may be a good time to start researching those types of businesses.
In a recession, companies that sell goods or services with a high price elasticity tend to earn less, while those selling more basic goods and services or those with a low price elasticity tend to find their sales increasing.
Car companies and airlines are examples of companies that will likely see a decrease in profits during a recession, while supermarkets and utility companies should fare much better. Also, these companies tend to see expansion in a recession, since investors are willing to pay a little more for the profits since there are fewer profitable companies to invest in.
For the savvy investor, volatile markets can produce opportunities by trading in derivatives such as options. Some strategies allow an investor to profit from increased market volatility - either upwards or downwards - while losing money if the price stays static. It’s quite rare for prices to stay static during uncertain times such as recession, which can make derivatives trading very profitable.
Regardless of the market situation, financial markets are here to stay and there will always be opportunities. Some companies will thrive during recessions, giving investors an opportunity to make money. Others will decline, which is also an opportunity to sell short or buy your favorite company stock at a discount. Ten years from now, stock markets will most likely be higher, and we will look back and wonder what all the fuss was about.
After learning about recessions, the impact they will have on the markets, learn how to capitalise on opportunities presented by a downturn economy, and start developing your profitable trading strategy through a combination of fundamental analysis and technical analysis by enrolling on one of our award winning, accredited trading courses.
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