What is an economic recession?

Simply put, a recession occurs when the economy stops growing and begins to decline for two consecutive quarters. This is negative for several reasons. Primarily, a recession impacts the quality of life for families and creates a bad environment for investments. In this Hapi article, we will explain the causes of an economic recession and its consequences on the US Stock Market.

How is an economic recession defined?

A recession is a significant, widespread, and prolonged decline in economic activity. Recessions reflect a drop in spending within an economy. A recession is a part of the economic cycle where production typically declines, unemployment rises, and investment and consumption decrease. Popularly, recessionary periods are known as “lean times.”

It’s important to note that a recession is not the same as a bear market or a bear market in the Stock Market. Nor is it a market crash. Stock market movements don’t always reflect what’s happening with economic activity.

However, they are closely related, as bear markets usually precede recessions or a crash could trigger a recession. That’s why it’s essential to understand this concept to make the right investment decisions.

What is a technical recession?

When a country's Gross Domestic Product (GDP) declines for two consecutive quarters, it is said to have technically entered a recession. The problem with this approach is that it fails to account for other important factors to gauge the true state of the economy. Hence, there is no consensus among economists on this definition of a recession.

The NBER's definition of recession

The National Bureau of Economic Research (NBER) is responsible for determining the start and end of a recession in the United States. According to their [view], an economic recession not only involves a decrease in GDP but also declines in personal income, employment, industrial production, and retail sales.

This is the most influential opinion on the presidency and the authorities of the banking system, like the Federal Reserve (FED). The NBER's stance depends on judgments and opinions made by academics, rather than a mathematical formula designed to signal a recession as soon as it begins.

For example, the depth of the economic decline caused by the COVID-19 pandemic in 2020 led the NBER to designate it as a recession, despite its relatively short duration of two months.

Learn some causes of a recession

• Economic shocks
• An unpredictable event that has a strong impact on the entire economy, such as a natural disaster, armed conflict, or pandemic. The latest example is the brief recession that occurred in reaction to COVID-19. Now, the invasion of Ukraine and tensions in Taiwan are also shocks to the economy.
• Loss of consumer confidence
• When consumers worry about the state of the economy, they cut back on spending and save as much money as they can. Since about 70% of GDP depends on consumer spending, the entire economy can slow down dramatically.
• High interest rates
• High-interest rates make it expensive for consumers to borrow money. This means they are less likely to spend, especially on major purchases like homes or cars. Businesses will also cut back on spending and growth plans because the cost of financing is too high.
• Asset bubbles
• In an asset bubble, the prices of investments rise rapidly, far beyond their fundamental value. These high prices are only supported by artificially inflated demand, which eventually fades, and the bubble bursts. At this point, people lose money, and confidence collapses. Consumers cut spending, businesses lose capital, and the economy enters a recession.

Why do stocks fall during a recession scenario?

When economic activity slows, spending decreases, earnings drop, and stock prices tend to fall. This happens for three main reasons in investor expectations:

1. Lower earnings per share

The first is that a recession reduces the present value of stocks, as lower economic growth leads to reduced future earnings for companies.

2. Worsening financial condition of companies

The value of assets and other investments that companies hold falls during recessions. These assets serve as collateral or backing for taking on debt from banks and other financial institutions. As financing becomes more expensive and limited, the present value of corporate projects decreases.

3. Risk management among investors

Uncertainty has increased, meaning stocks are riskier and worth less. Investors want to take fewer risks, so they sell stocks to hold safer investments like bonds or cash.

How has the US Stock Market behaved during recessions?

Typically, the stock market continues to fall for several months after a recession begins. Historically, the market hits bottom about six months after the start of a recession and usually begins to recover before the economy does.

Additionally, the S&P 500 (an index that includes the 500 largest companies in the US) surprisingly rose an average of 1% during all recession periods since 1945. This is because markets generally peak before recessions begin and bottom out before they end. Let's review how the stock market responded during recent recessions:

• March 2001 – November 2001: The main factor that led to this eight-month recession was the collapse of the dot-com industry (companies related to the internet). During the recession, between March and November 2001, the S&P 500 fell 8.2%.
• December 2007 – June 2009: The market experienced a sharp decline of almost 38% over the entire period. The collapse of the housing market led to the phase known as the Great Recession. The US GDP contracted for three consecutive quarters, and unemployment rates rose to 10%.
• February 2020 – April 2020: The market dropped by 34%. It was caused by the COVID-19 pandemic and lockdown policies that contracted global production. However, it was short-lived due to aggressive monetary stimulus.

How to invest during a recession?

Usually, confirmation of a recession is a good sign to start investing in the stock market again. As seen through recession history, the stock market falls before economic activity and also recovers first. In other words, the worst for stocks has passed before it ends for the rest of the economy.

For this reason, long-term investors prefer to hold their assets and wait for the bear market and recession to pass. Taking a long-term view usually yields good results, as the stock market tends to rise over many years.

Take advantage of the recession by buying shares incrementally

According to experts, an effective way to invest during recessions and not be frightened by the ups and downs of the stock market is to apply a strategy called *dollar-cost averaging (DCA) or incremental buying.

This strategy involves investing a constant amount periodically (monthly, quarterly, or annually) in your account on an investing app, which allows you to take advantage of the stock market’s upward trend in the long run. With Hapi, incremental buying is easier because you can buy without commissions or minimum amounts.

Seize the opportunity to buy at a discount

Since the prices of most assets have fallen, it presents a great opportunity to add more stocks to your portfolio. If you compare it to supermarket shopping, a bear market would be like a sale where what you are looking for has very attractive discounts.

Following that logic, it would be wise to use this period to invest more. Therefore, if you find values that are on discount, you can buy gradually with a long-term perspective. However, past stock market performance is not an infallible indicator of future results.

Consider how each sector behaves in a recession

Not all stocks behave the same during a recession. History shows that the consumer staples and utilities sectors perform best, as they tend to pay higher dividends than other sectors. Additionally, growth stocks (those from tech companies with fast-growing revenues) can drop since they are typically more volatile.

A useful concept for understanding the volatility of each sector is beta. Beta in finance is a measure of an asset's volatility relative to the general market. Simply put, beta shows how much a stock or sector's movement resembles that of an index like the S&P 500 (which has a beta of 1). Therefore, a sector with a beta greater than 1 has larger movements than the overall market. Professor Damodaran (NYU Stern) has compiled the beta information by sector for the public.

We’ve discussed the stock market, but how do cryptocurrencies behave during recessions?

In 2009, the creation of Bitcoin was a response to the Great Recession caused by the Financial Crisis. This technology introduced a new way to transact without relying on financial institutions like banks, which were bailed out by the government at the public's expense.

Due to its young age, we still don’t have much data to analyze cryptocurrency behavior in crisis contexts. In the case of Bitcoin, because of its limited supply, some investment funds expected it to behave similarly to gold during a recession.

However, that did not happen in the 2020 recession. In fact, Bitcoin experienced much more volatility than gold. Despite that, months after the economic downturn, Bitcoin and other leading cryptocurrencies surged, with many cases rising over 300% to reach new highs.

Like stocks, cryptocurrencies have shown a sustained decline that has led current prices to levels similar to mid-2020. Therefore, if you were interested in buying crypto or companies related to this sector, this would be an excellent time to invest at lower prices.

If you want to invest easily and securely, all you need to do is open an account on Hapi, an app to buy US stocks and cryptocurrencies.