What Does a Recession Mean for Stocks
In this article, we will review the relation between recessions and stocks and how stock market trends are impacted. If a recession is coming, what does it mean for your stocks?
We recently heard the „R“ word in the news: Recession. What does that even mean, and more specifically, what does it mean for stock markets? Here is some background.
What does “recession” mean?
The economic definition of a recession is two subsequent quarters of negative economic growth. Growth is negative if businesses have a lower output compared to the previous quarter, meaning they earn less money.
Why is a recession a problem for stocks?
Stock prices are the sum of their discounted future earnings. In a recession, companies need to lower their earnings projections because there is less product demand. As a result, investors need to lower the valuations of the stocks because the sum of future earnings is now worth less.
In other words: Businesses earn less money. Hence, they are worth less.
Is a recession coming?
There are several reasons why the US economy might face a recession in 2023. First, the central bank has increased interest rates incredibly fast this year to combat rising inflation. That makes it harder for businesses to get access to money. They might have to slow down their growth, meaning there is less demand.
Also, the war in Ukraine has increased energy prices. That’s not so much an issue for the US economy, though, as the US is largely energy-independent. Quite the opposite, actually: The US is an energy exporter.
Rising energy costs are especially an issue in Europe, making the risk of a recession higher than in the US.
What to do?
Stock investors don’t need to avoid stocks in a recession categorically. For long-term investors, picking up stocks when valuations are depressed is wise. That increases the chance for future capital gains.
Short-term investors who want to avoid the risk might want to shift into cash or bonds to avoid their net worth being reduced when a recession hits. They might also reallocate capital to more quality and recession-proof businesses.
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