The escalating coronavirus pandemic that triggered a bear market in U.S. stocks in early 2020 looks to have tipped us into a possible recession. How can you prepare for and invest during a recession and bear market?
Economists’ definition for recessions has shifted over time, but one thing’s for certain: recessions cut deep across stock market history. The Great Recession and financial crisis of 2008–09 remains a fresh memory for many market professionals. The escalating coronavirus pandemic that triggered a bear market in U.S. stocks in early 2020 looks to have tipped us into another recession.
How can you prepare for and invest during a recession and bear market? Recessions happen for different reasons and often coincide with or accompany bear markets in stocks. But many fundamental principles of investing and portfolio strategy remain constant, said Viraj Desai, senior manager, portfolio construction at TD Ameritrade Investment Management, LLC.*
According to Desai, examining how stocks have responded in previous recessions, as well as common mistakes investors make, can help inform and enlighten your portfolio strategy. Here are a few basics on recessions and markets, plus three mistakes many investors make during a pullback.
Recessions have traditionally been defined as two or more consecutive quarters of shrinking GDP. But according to the National Bureau of Economic Research, which is considered the official arbiter, the definition of a recession today is more nuanced and incorporates other economic indicators.
A recession “is a significant decline in economic activity spread across the economy, lasting more than a few months [and] normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales,” according to the bureau’s website.
Most, but not all, recessions have included two or more quarters of declining real (inflation-adjusted) GDP, the bureau said. The economic downturn following the September 11, 2001 terrorist attacks didn’t have two consecutive quarters of declining GDP, but it still qualified as a recession. By contrast, in the Great Recession of 2008–09, four out of six quarters posted negative GDP.
Recessions historically have been triggered by a few factors, including a supply or demand shock in a global commodity like oil, for example, according to Desai. The current crisis and potential recession stem from a massive demand shock as the coronavirus pandemic brought economic activity to a near standstill.
Another form of recession could be driven by the Federal Reserve. For example, in the early 1980s, the Fed sharply hiked benchmark interest rates in an effort to tamp down soaring inflation. If the central bank is too hawkish in its monetary policy, or not accommodative enough, economic growth can suffer. More recently, Fed policy makers have shifted the other direction: slashing rates to near zero, buying government securities, and taking other steps to provide market “liquidity” during a crisis.
Another form of recession is sort of a credit “re-set,” a period of rapid deleveraging in the wake of an asset bubble bursting, such as what happened in housing (the 2008 financial crisis) or technology stocks (1999–2000), Desai said.
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Economies and markets move in long-term cycles, with peaks and troughs that can be many years apart. The 11 U.S. recessions since World War II lasted about 11 months on average, according to the National Bureau of Economic Research. Going back to 1854, 33 recessions averaged about 17.5 months.
Over recent decades, economic expansions have gotten longer and contractions shorter, although that doesn’t necessarily mean the current downturn will be short-lived. The S&P 500 Index and other widely followed market gauges often serve as the canary in a coal mine.
“When we enter recession, we’re often coming off a period of euphoria or irrational exuberance that creates lofty valuations” for stocks, Desai said. But if investors and traders get a whiff of recession, such sentiment rapidly reverts. “As we start to get inklings of a possible recession, the S&P 500 Index and other financial market benchmarks usually provide signals of trouble ahead.”
U.S. stocks’ record bull run came to an abrupt halt over the winter amid growing coronavirus concerns. Since posting a record high on February 19, the S&P 500 Index tumbled as much as 34%, well beyond the 20% decline that defines a bear market. There have been 13 bear markets since World War II that posted declines of 32.5% on average and lasted about 17 months from peak to trough, according to Sam Stovall, chief investment strategist at CFRA.
But as always, past performance doesn’t guarantee future results.
In a word or two: speed and volatility. The S&P 500 took only 22 calendar days to sink into bear market territory this year, compared to an average of 251 days for the other 12 post–World War II bear markets, according to Stovall.
The 24/7, lightning-round nature of today’s markets combined with a global health crisis on a scale unlike anything in the modern era created a particularly volatile mix, Desai pointed out.
“This is one of fastest and deepest market downturns and economic contractions we’ve ever experienced,” Desai explained. “The speed and magnitude of what we’re experiencing, coupled with loss of life, creates exponentially more stress, anxiety, and fear.”
The market’s recent behavior has been dramatic in terms of volatility and price swings, “but at the end of the day, fundamentals of stock investing are still the same,” Desai said. That makes it particularly important to try to keep emotions in check, maintain a disciplined investing strategy, and try to avoid these three common investor mistakes during market downturns.
Mistake 1: Selling at the bottom of a market.
Nose-diving markets are often fueled by panic selling, which any investor with a long-term plan should avoid getting sucked into. Unload stocks during a slump, and you may just be locking in losses and eliminating any prospect of gains if prices recover. “It tends to be more prudent to ride out volatility and wait for the market to recover,” Desai said. “History shows the best opportunities to accumulate assets often come after the worst periods for markets.”
Mistake 2: Trying to time the market using economic data.
Many economic readings are lagging indicators—snapshots of a previous month or quarter. Investors might consider macroeconomic data in the context of company or industry fundamentals, Desai said. “Looking at macro data by itself can potentially cause you to be late to react to what the market is doing,” he explained. “It might be better to focus on valuations and the prevailing market sentiment of asset classes as well.”
Mistake 3: Being too concentrated in certain assets and not diversifying.
Too many eggs in one market sector basket can be a recipe for trouble, and bear markets can change the way some companies are valued. For example, before the 2008–09 financial crisis, many financial companies were considered blue-chip, high-dividend-paying stocks, Desai said. “But as these companies collapsed, their market value largely disappeared,” he said. “If you’re not diversified, markets can re-price certain stocks permanently.”
Other steps for investors to consider during bear markets and otherwise turbulent times? Understand how dollar-cost averaging can help you scale in and out of positions, recognize and avoid “bear traps,” and know key differences between bear markets and bull markets.
Plus, maybe consider one other thing: chill out and talk to an advisor or other market professional, someone who’s ridden out rough markets before and could help you navigate through uncertainty. Above all, don’t let emotions get the best of you.
“In markets like we’ve had recently, it’s a good idea to check our emotional temperatures, turn down the noise, and separate what we know from what we don’t know,” Desai suggested. “Step back, focus on objectives, and consider diversification.”
Diversification does not eliminate the risk of experiencing investment losses.
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