The U.S. economy has been through quite a bit over the past couple of years. Some suggest what we’re actually seeing is the beginning of a recession, and there’s no question that the U.S. stock market is acting like that’s the case. A 2022 selloff has compressed stock valuations and created significant volatility.
Stock prices aren’t the only prices plummeting either. Cryptocurrencies like Bitcoin and Ethereum have also taken a dive.
As interest rates increase, Wall Street is seeing signs of the end of the bull market, and economists are warning of a coming recession. What can we expect to see from the stock market if a recession is happening? And what should you do as an investor to protect your wealth?
How Much Do Stocks Drop in a Recession?
Historically, recessions have always triggered a bear market. With less money going around, consumers are more apt to save than spend, which sends corporate profitability down the tubes. During these times, every stock market index from the Dow Jones Industrial Average to the Nasdaq and S&P 500 index turns red and billions of dollars are wiped out of the global market cap.
But is it really that bad? How badly have recessions affected the stock market in the past?
How Recent Recessions Affected the Stock Market
The chart below shows historic S&P 500 returns during recent recession periods:
|Era||S&P 500 Top||S&P 500 Bottom||S&P 500 Return|
|1980-82 Recession||475.10 (Nov. 1980)||317.52 (July 1982)||-33.17%|
|1987 Recession||833.40 (Aug. 1987)||576.90 (Nov. 1987)||-30.78%|
|1990 Recession||796.95 (June 1990)||658.46 (Oct. 1990)||-17.38%|
|2000-02 Recession||2,539.08 (Aug. 2000)||1,302.00 (Sept. 2002)||-48.72%|
|2007-09 Recession||2,144.34 (Oct. 2007)||1,001.19 (Feb. 2009)||-53.31%|
|2019-20 Recession||3,634.63 (Dec. 2019)||2,894.74 (March 2020)||-20.36%|
Markets have been down substantially during every period of poor economic activity since 1980. If you go back farther, you’ll see more of the same.
However, there’s no telling how far stocks will fall when a recession takes hold.
Think about it this way: the dot-com bubble burst of the early 2000s was the worst economic period in the U.S. since the Great Depression. From August 2000 to September 2002, the S&P 500 fell from 2,539.08 to 1,302.00 in a dramatic 48.72% fall from glory.
The market took an even bigger hit in the 2008 financial crisis. The S&P 500 was down 53.31% at the end of the 2008 recession.
Fast forward to 2020, and while the world was in a panic from the worst global pandemic in living memory, the S&P only gave up about 20%. And it quickly recovered.
Given this data, short-term declines can be expected any time a recession takes hold. However, the extent of those declines is largely dependent on investor morale during the economic crisis. After all, the market is a careful balance between supply and demand. If more investors are willing to hold their positions through economic blues, you can expect to see fewer declines.
Right now it looks like 2022 is shaping up to be one for the chart above. In December 2021, the S&P 500 was at 4,942.53. By late May 2022, the index had fallen to around 3,900, giving up about 20% of its value.
Stocks to Avoid During a Recession
There are always winners and losers in the stock market whether there’s an economic contraction or not. There are two different types of stocks:
- Cyclical Stocks. Cyclical stocks are known to ebb and flow with economic trends. These include high-growth stocks like tech stocks that are dependent on consumers having extra money to spend on the latest and greatest technology.
- Non-Cyclical Stocks. Non-cyclical stocks are more stable regardless of economic conditions. These stocks often represent companies that provide necessities like utility services.
It’s best to avoid cyclical stocks when the economic cycle is turning negative. Some of the biggest sectors to avoid during an economic recession are:
- Technology. Technology companies spend massive amounts of money on research and development to stay ahead of the curve. However, consumers are less likely to splurge to buy the latest technology when economic conditions are poor. These companies tend to take big hits during economic recessions.
- Restaurants. You’re more likely to save than spend during a recession, meaning you’re going to want to eat more of your meals at home. Restaurant chains take a big hit during recessions as a result.
- Travel Companies. Hotels, airlines, and theme parks all feel the pain when economic pressure on consumers is high. The last thing you’re going to do when you’re worried about money is to plan a pricey vacation.
- Automobile Manufacturers. You’re less likely to make a big purchase when economic conditions are poor. That new car may have to go on the back burner until the economy improves.
When considering new investments during a recession, it’s important to ask yourself whether the company offers a product or service people will want even when economic times are tough. If the answer is no, chances are it’s a cyclical stock you should avoid until economic conditions improve.
Some classes of stocks tend to do better during economic downturns than others. Those are non-cyclical stocks.
These stocks tend to follow a slow and steady growth pattern regardless of the state of economic growth. Some call these stocks “recession-proof,” but of course any stock can rise or fall at any time.
Some non-cyclical sectors to consider during a recession include:
- Utilities. You may be willing to adjust your thermostat a couple of degrees when you’re worried about money, but you’re not going to turn your electricity off. Utilities are always in demand, regardless of the state of the economy.
- Health Care. Health care is a booming industry. Medical ailments don’t care what the economy’s doing when they strike. As a result, the health care industry is a great place to invest your money when you’re worried about an economic downturn.
- Military Contractors. Like medical ailments, geopolitical disagreements and national security threats happen regardless of economic conditions. It’s important for the military to have the latest and greatest in defense technology when it’s time to defend the country. Military spending may slow in the toughest economic times, but it never stops.
- Low-Cost Retail Chains. You’re more likely to shop in low-cost stores than higher-end retail outlets when you’re worried about money. This creates an economic shield for companies that provide low-cost consumer goods.
What Should Investors Do in a Recession?
Recessions are part of the normal economic cycle, but when they hit and markets go from bullish to bearish, it can be hard to decide what to do. Although I can’t give you personal investment advice, I can say following the steps below will set you on the right path:
Step #1: Stay Calm
It can be scary to watch markets turn red, especially when you’ve done everything right to build up a nest egg in the stock market. However, as mentioned above, recessions are a normal part of the economic cycle.
Knowing there have been so many recessions throughout history can make it easier to deal with them as they come up in the future. Stay calm and think rationally. You’ll make it through this!
Step #2: Dump Cyclical Stocks
You don’t want cyclical stocks in your portfolio during a recession because they take the biggest hits. Start by combing through your portfolio and dumping any stocks, exchange-traded funds (ETFs), or mutual funds in cyclical sectors.
Step #3: Reassess What’s Left
If you believe a recession is taking place, chances are stocks have already begun to fall. Take a look at the non-cyclical stocks in your portfolio and take note of how they’ve performed since the overall market started to take a dive.
You want to hold stocks that are either in the green, flat, or only slightly red. If any of your positions have had reactions you’d expect from cyclical sectors, it’s time to sell them.
Step #4: Increase Your Safe-Haven Holdings
Safe-haven investments are investments that tend to hold their value in the face of tough economic times. These include investments in assets like bonds, gold, and even cash.
Yes, you read that right, cash.
After all, the telltale sign of a recession is falling prices. When prices fall, your cash buys more, meaning it increases in value.
Nonetheless, decide which safe havens meet your needs as an investor and increase your holdings in them.
Step #5: Invest In Non-Cyclical Stocks
Next, any unused money that remains should be invested in non-cyclical stocks. Dive into utilities and health care for the opportunity to generate some upward movement while the economic cycle gets over its rough patch.
Step #6: Stay On Top of the Market
Economic recessions don’t last forever. Many don’t last long at all.
You’ll want to readjust your portfolio to take a bullish stance as the signs of a recession fade because some of the biggest gains in the market tend to happen shortly after the worst declines. Keep a close eye on the market so you don’t miss your opportunity to bank on the economic rebound.
Economic downturns happen from time to time. These events are often fuelled by unforeseen circumstances that simply can’t be controlled.
The worst thing you can do as an investor in the face of an economic recession is panic. It’s more important than ever to stay calm and think logically when things are tough.
Follow the steps above, do your research when making stock picks, and shield yourself from the storm with a larger allocation to safe havens, and you’ll make it to the other side in one piece!