Please ensure Javascript is enabled for purposes of website accessibility

3 Critical Lessons on Economic Recessions

By Catherine Brock – Jul 14, 2020 at 8:08AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The U.S. is officially in a recession. Here's what you should know.

It was early June when the National Bureau of Economic Research (NBER) announced that the coronavirus recession began on Feb. 20, 2020. The news didn't surprise anyone. Of course the economy had contracted -- that's what happens when much of the country shuts down temporarily to fend off a global pandemic. Households, too, were already feeling recession shockwaves, in the form of massive unemployment.

Still, knowing that this recession has been under way for months does add some important context. Given how recessions have historically behaved, that context can influence your investment approach for the remainder of 2020. Here are three critical lessons on recessions, and how to apply them.

Woman looking at her laptop and holding her head in frustration.

Image source: Getty Images.

1. Stock market trends can predict economic ones

Recessions and bear markets often happen together, but they're not one and the same. A recession is official once the economy has two consecutive quarters of negative Gross Domestic Product (GDP). A bear market, on the other hand, is a period of extended share price declines, during which prices fall 20% or more from their previous highs.

History shows us that bear markets often start before the recession begins and, importantly, reverse while the recession is still ongoing. Remember the Great Recession of 2008? That economic cycle ended in June of 2009, but the stock market bottomed and turned positive three months earlier. Those predictive gains are fueled by optimistic investors, who sense an economic recovery is on the way.

That dynamic helps explain why the stock market rallied back so quickly after the March crash, even as the economy still shows high unemployment and low production. Investors largely believe we've turned the corner, economically speaking, and will be back to growth by year-end. That outlook drives share prices up, for now.

The takeaways here? Recognize that recessions and bear markets don't move in lockstep. And don't be afraid to invest during an economic recession. Sometimes, the stock market recovery is already under way by the time the recession is made official. Do take the precaution, though, of only investing cash you won't need to use for five years or so -- just in case. Should the pandemic worsen significantly, that may influence investor sentiment and drive another cycle of falling share prices. Only invest if you're emotionally and financially prepared for that possibility.

2. On average, recessions last 11 months

History says recessions last anywhere from six months to 18 months, with the average duration being just over 11 months. If history repeats itself, the coronavirus recession might continue through the end of 2020 or, possibly, into the middle of 2021.

Use that timeline to clarify what your cash needs might be for the next year and how that affects your investment activities. For example, say you've lost your job and stopped making retirement contributions. Rather than feel despair because you assume your retirement hopes are dashed, run some scenarios. Look at how your retirement plan is affected if you restart your contributions in six months or 12 months. Identify a contribution schedule that would get your plan back on track. Focus on what you will do once this recession is over, not what you can't do while the recession drags on.

3. In a recession, cash is king

You know what it takes to survive a recession personally -- an ample store of cash, low expenses, minimal debt, and a stable income outlook. The same dynamic applies to businesses, too. To stay invested while hedging against a longer-than-expected economic recovery, add financially resilient companies to your portfolio. These organizations typically power through recessions with the least amount of disruption. Signs of financial resilience include low debt, strong cash flow, stable profitability, and a consistent or rising dividend. A recognized brand, loyal customer base, and experienced management team also contribute.

Recessions are temporary

Economic recessions, like bear markets, are always temporary. Assuming you have enough cash on hand to survive any potential income loss, you can and should stay invested through both. If you're worried about portfolio volatility through the remainder of this year, look for opportunities to add financially resilient companies or even low-cost, large-cap mutual funds to your holdings.

The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.