Economic recession and the stock market
What is an economic recession and how it may have an effect on the stock market?
“In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock, the bursting of an economic bubble, or a large-scale natural or anthropogenic disaster (e.g. a pandemic). In the United States, it is defined as “a significant decline in economic activity spread across the market, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”. In the United Kingdom, it is defined as a negative economic growth for two consecutive quarters.
Governments usually respond to recessions by adopting expansionary macroeconomic policies, such as increasing money supply or increasing government spending and decreasing taxation.”
A decline of the economic activity is bad news for the stock market and the general economy
We like the definition that an economic recession “is defined as a negative economic growth for two consecutive quarters.” mentioned above. For the US economy, we had the first quarter of negative economic growth, and most probably the second quarter of 2020 will be even worse in terms of negative economic growth. The weekly jobless claims still show that many people file for unemployment insurance benefits. And many companies warn about their future profitability or avoid to make any forecasts at all. It will be a tough year to choose stocks to buy and stocks to sell. Why? Fundamentals should never be ignored about stocks and their valuation. And still, any selloffs may lead to short-term rallies as bargain hunters search for cheap stocks. Cheap stocks mostly related to their stock price, not their intrinsic valuation.
Stocks to avoid
Which stocks to avoid in an imminent economic recession? A few criteria to focus on for stock selection, investing and trading are:
- Large amount of debt, weak balance sheets, poor profitability, negative or declining free cash flows are all signs of weakness.
- Declining revenue growth, EPS growth same as above
- Stocks with an abnormal price increase without any catalyst to suppot the rally are prone to correction
- Stocks with a very high P/E or even worse a negative P/E are dangerous stocks
- Defensive stocks, such as Utilities, Consumer Staples, Healthcare, are considered safer stocks during an economic recession.