A recession is defined as a shrinkage of the economy for at least six months. Consumer spending slows, banks are more wary to lend and interest rates may rise. The stock market is a reflection of this contraction in consumer spending and the resultant lack of private sector investment. Investor and consumer confidence temporarily becomes more conservative, but this can lead to new opportunities.
Stock prices in many sectors fall during recessions. This is often not the case in sectors dealing in staple items such as food, drink or fuel. Discretionary spending slows, yet standard non-discretionary spending often stays the same. Stocks of well-known, firm and solid companies such as Wal-Mart or General Motors can go entirely unaffected, since there is no chance that the recession will destroy these firms. In fact, these companies might do well, because money moves from smaller, riskier companies to the giants.
Small, start-up firms quickly see a dearth of capital during a recession. If money does not move to the larger, blue-chip stocks, it may move to the bond market in anticipation of rising rates. This is a gamble, because the Federal Reserve might keep rates artificially low so as to encourage lending and investment. Since smaller and riskier companies may see a sharp drop in prices, experienced investors may well use this time to buy up the now-undervalued stocks, gambling that, when the recovery arrives, these companies will grow significantly, earning a large capital gain. Buying bargain stocks in times of recession is a common but risky strategy.
Many investors try to keep ahead of the business cycle. This is called “sector rotation.” It means that investors try to predict the future recessions and their recovery cycles by moving money to those sectors that do well during different points in the cycle. When a recession is expected, these investors will take their cash out of diamonds, consumer electronics or fitness companies and move them to those specializing in staple goods. Such investors are not looking for quick profits but a steady capital gain that will protect their principal.
The value of options increases during a recession. The development of a slowing economy, especially for a long period of time, leads to increase market volume. Trading increases, which means that options, or the right to buy or sell a stock, become valuable. Options to sell can be sold separately from the stock itself, which means that, even if stocks are losing value, owning the rights to trade those stocks will rise. You can being buying options when the business cycle heads to recession, because money is made regardless of the value of the stock. When the market begins to contract, trading increases, and the value of options increases across the board.
- Ryan McVay/Photodisc/Getty Images