The stock market usually enters a bear phase during a recession (where stocks are falling or are already at a low). Investors are typically wary of investing afresh in such a market as the chances of stock prices falling further keep them away. To further complicate a dismal situation, a recession has no expiry date – it can last a few months or drag on for years.
Another perspective about a bear market is to look at it like a stock market sale, where shares are available at significant discount to their normal levels. However, like any experienced shopper knows, not everything on sale is a good bargain. Investors need to avoid being lured into buying anything and everything because it is cheap. However, if investors choose the right strategy in a sale, they can get great bargains from a long-term investment point of view.
Why do stocks fall in recession?
Typically, economic activity declines during a recession. Companies are unable to grow their profits due to the slowdown in revenue. Individuals prefer to save than spend, which, in turn, affects company revenues. Companies then postpone or cancel capacity expansion or end up with surplus capacity. This, in turn, freezes fresh hiring or even triggers layoffs, which cascades into weaker sentiment among individuals about spending. Governments earn comparatively low revenues from taxes, and may thus curtail their expenditure on various projects. Overall, the economy goes into a negative loop of less output and subdued demand.
The stock markets react when investors anticipate a recession. One of the concepts that explains stock price says it is the present value of future cashflows that the company could earn. A recession would invariably indicate lacklustre future sales, and hence, low profits, which, in turn, would lower the present value of future cashflows. This translates into a fall in share prices.
Recession and investment opportunity
Long-term investors would however, note that economies recover from recessions and so do stock markets. Typically, stock market changes lead economic cycle changes, meaning the stock market would fall first, and then a recession or slowdown would materialise in the economy. However, any fall in the stock market is also an opportunity for investors to pick up stocks at low prices, especially from a long-term perspective. Even if investors gather the courage to invest, the key questions remain – when to invest and how to invest (strategy). Can investors accurately gauge the lowest price or ‘time’ the market in a bear phase? Although this can be very appealing to try, investment professionals (including fund managers) would advise strongly against such a move, as there is no formula to accurately predict the right time to invest. Therefore, the focus should be on investment strategy.
There are two main investment strategies usually followed by investors.
1. Equity mutual funds
In this strategy, instead of trying to invest in individual stocks (even if they are available at a bargain), investors can opt to invest through mutual funds. When stock markets recover from a bear phase, the recovery is usually broad-based (several stocks go up together). Investing in a diversified mutual fund is preferable as investors can benefit from such broad-based recovery, rather than betting on a select few stocks. The return from this strategy would be less than that from some of the best-performing stocks at the top of the returns table. However, the risk is also lower than associated with investing in poor stocks that are unable to recover even if the rest of the market does.
2. Direct stocks
This strategy is suitable for only those investors with adequate knowledge of how the stock market operates and what causes price movements. It is also suitable for investors with greater risk appetite or the ability to absorb losses without financial distress. Such investors are also aware that certain sectors are more resilient than others in a bear market. For example, companies from sectors like consumer, pharma, and healthcare are more resilient due to the nature of demand for these goods and services. Thus, knowledgeable investors avoid cyclical sectors such as real estate where the turnaround period can be long, spanning several years.
More knowledgeable investors who conduct in-depth research on companies are better positioned to pick individual stocks for investment. One such filter for companies is a proven track record of recording growth even through a recession.
Overall, recessions are opportunities for long-term investors to participate in the stock market at bargain prices. However, the time horizon in such investment should be long term, and investors need to have a sound strategy that suits their investment style and knowledge of the stock market.