What Past Recessions Can Teach You

Investor beware? Learn all about a down market with our recession survival guide.

No matter how much experience you have as an investor, the fear that accompanies economic downturns tests your ability to stay rational and focused. At first glance, it seems like every time a new challenge faces the markets, it's different from anything you've ever seen before.

However, you can find common themes that come up repeatedly during periods of slowing growth. By looking at similar episodes of past market turmoil, you can gain hints about ways to defend your portfolio and make money, even in tough times.

Avoid the epicenter
Most recessions affect certain industries much more than others. For instance, from 2000 to 2001, the economy suffered three quarters of falling GDP, largely because of the end of the tech bubble. Stocks that had risen the most until that point -- mostly tech stocks like Microsoft (Nasdaq: MSFT  ) , Intel (Nasdaq: INTC  ) , and Cisco Systems (Nasdaq: CSCO  ) -- were hit disproportionately hard in the ensuing bear market.

Similarly, recessions in the 1970s and 1980s, which were largely caused by skyrocketing energy prices, affected energy-intensive industries like steel and aluminum production, hurting producers like U.S. Steel (NYSE: X  ) and Alcoa (NYSE: AA  ) for years to come.

In contrast, when you go beyond the sectors at the heart of the slowdown, you'll find some industries that are in a better position to weather the storm. But keep in mind that those industries won't necessarily be the same in every recession. For instance, many see health-care stocks as a traditional defensive play. Yet several health-care insurers, including WellPoint (NYSE: WLP  ) , have taken big hits so far this year as consumers look to cut back on increasingly expensive coverage for medical costs. Furthermore, while tech was obviously the focal point for the 2000-2002 bear market, many cash-rich tech stocks now appear well-insulated from the troubles that have hit financial stocks.

When it's official, it's too late
Another key component of investing during recessions is recognizing that the markets usually signal the recession before government statistics actually confirm it. For instance, by the first quarter of 2001 -- the second quarter in which gross domestic product had fallen -- the S&P 500 was already down 25% from its highs, and the Nasdaq had lost half its value. In fact, those waiting for the textbook definition of two consecutive quarters of falling GDP never saw a recession at all.

Even more extended downturns confirm this lag time. For instance, an official recession didn't start until the end of 1974 -- three months after the S&P 500 bottomed in September. The timing in 1980 was a bit better, but another two-quarter GDP drop in 1982 occurred close to the market's low point.

Opportunities for explosive growth
Perhaps the most interesting thing about investing in a recession is how well stock investors do in the immediate recovery. In 2003, the S&P 500 index jumped more than 26% following the bear market. In 1991, the S&P showed the same 26% advance, while stocks rose 31% in 1975. The periods immediately after recessions often have the highest returns -- for instance, it took three years, from 2004 to 2006, for the S&P to rise as much as it did in 2003 alone.

Here's the primary conclusion you should draw from past recessions: While falling stock prices can hurt, they eventually stabilize, often creating extraordinary returns. If you wait until the all-clear sounds before putting your investing dollars back to work, you'll probably miss out on the strongest gains.

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