The terms recession and stock market crash are often used interchangeably in spooky headlines about what might be ahead for the economy.
The reality is that while the stock market may dip due to the psychological effects of a recession, there isn't a perfect cause and effect relationship between the two. And unfortunately, scary headlines about both often push the average investor to do the exact opposite of what they should do when a recession or stock market lull actually happens.
In this video from our YouTube channel, we explain the difference between a recession and a stock market crash, examine how the stock market tends to perform during and after recessions, and what investors should do when these types of macroeconomic events occur.
Narrator: Hi, and welcome to The Bottom Line. In this video we're going to explore what a recession is and whether or not the next one could cause the U.S. stock market to crash.
It's important to understand that a recession is an economic term that refers to a general slowdown in economic activity, and is usually defined as two consecutive quarters of negative GDP growth.
Recessions are tricky to predict because they typically start before anyone even knows they're happening and end before economists have enough data to know they're done. It's also worth mentioning that they're usually pretty short.
Since the end of the Great Depression, there have been 13 recessions in the U.S., and 9 of those lasted less than one year.
While the effects of a recession often cause the stock market to fall, recessions don't cause stock market crashes.
Stock market crashes are sudden drops of stock prices, and they're unusual events that are often driven by panic.
In general, the stock market tends to follow the U.S. economy.
There are countries all over the world that are dealing with all kinds of economic issues right now. For example, China is experiencing its worst manufacturing output in more than 17 years and Germany's GDP is shrinking.
Meanwhile the U.K. is dealing with a laundry list of issues surrounding Brexit, and Italy is already in a recession.
Even with all of those problems, the U.S. stock market has performed incredibly well.
Generally speaking, as long as the U.S. economy is strong, then our stock market will be strong as well.
Of course, when a recession does come along, the stock market tends to react negatively.
The stock market's average return during recessions dating back to the mid-1950s has been negative 1.5%.
But that doesn't mean that stocks get crushed during a recession. In fact, the market actually posted gains during four of the last eight recessions.
It's also important to remember that stocks tend to perform very well in the years immediately following recessions.
On average, the S&P 500 generates total returns of more than 15% in the year after a recession ends, and 40% in the three-year period following the economy's return to growth.
So what should investors be doing as worries of a recession rise?
Because it's impossible to predict with accuracy when a recession will occur or how long it will last, trying to time a recession is generally a bad idea.
Unfortunately, one of the biggest mistakes people make during a recession is to sell their stocks after the market has already fallen sharply, because they expect it to fall even more.
The stock market then starts to recover before people are ready to reinvest, resulting in them missing out on the market's recovery.
The bottom line is that recessions are going to happen and they'll most likely negatively affect the stock market.
But those negative effects will probably be short lived. Which is why you should invest in businesses that can make it through the tough times, and then hang on to those investments for the long haul.