Recessions are a fact of life. Along with periods of growth, the economic cycle includes periods of decline. The latter generally cause the most concern for investors, but luckily there are strategies available to limit portfolio losses and even log some gains during a recession. (See also, "Tutorial: Economics Basics.")

What Is a Recession?

A recession is an extended period of significant decline in economic activity. In general, economists call two consecutive quarters of negative gross domestic product (GDP) growth a recession, but other definitions exist. Recessions are characterized by faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and weakening sales and production. This is not exactly the environment that would lead to higher stock prices or a sunny outlook on stocks.

As they relate to the market, recessions tend to lead to heightened risk aversion on the part of investors and a subsequent flight to safety. On the bright side, though, recessions predictably give way to recoveries sooner or later. (See also, "Recession: What Does It Mean To Investors?")

Keep an Eye on the Horizon

The key to investing before, during and after a recession is to keep an eye on the big picture, rather than trying to time your way in and out of various market sectors, niches and individual stocks. Even though there is a lot of historical evidence for the cyclicality of certain investments throughout recessions, the fact of the matter is that timing such cycles is beyond the scope of the retail investor. There's no need to be discouraged, however, because there are many ways an ordinary person can invest to protect and profit during these economic cycles. (See also, "Market Cycles: The Key To Maximum Returns.")

First, consider the macroeconomic aspects of a recession and how they affect capital markets. When a recession hits, companies slow down business investment, consumers slow down their spending, and people's perceptions shift from being optimistic and expecting a continuation of recent good times to becoming pessimistic and uncertain about the future. Understandably, they tend to become frightened, worry about prospective investment returns and scale back risk in their portfolios. These psychological factors manifest themselves in a few broad capital market trends.

Within equity markets, investors' perception of heightened risk leads them to require a higher potential rate of return for holding equities. For expected returns to go higher, current prices need to drop, which occurs as investors sell riskier holdings and move into safer securities such as government debt. This is why equity markets tend to fall, often precipitously, prior to recessions as investors shift their investments.

Investing by Asset Class

History shows us that equity markets have an uncanny ability to serve as a leading indicator for recessions. For example, the markets started a steep decline in mid-2000 before the recession of March to November 2001. But even in a decline there is good news for investors, since pockets of relative outperformance can be found in equity markets.

  • Investing in Stocks in a Recession
    When investing in stocks during recessionary periods, the relatively safest places to invest are in high-quality companies with long business histories, as these should be companies that can handle prolonged periods of weakness in the market.

    For example, companies with strong balance sheets, including those with little debt and healthy cash flows, tend to do much better than companies with significant operating leverage (debt) and weak cash flows. A company with a strong balance sheet and cash flow is better able to handle an economic downturn and more likely to be able to fund its operations despite a tough economy. By contrast, a company with a lot of debt may be damaged if it can't handle its debt payments and the costs associated with its continuing operations. (See also, "What Is a Cash Flow Statement?" and "Breaking Down the Balance Sheet.")

    While a company's fiscal probity is important, however, make sure it is not cutting costs in the wrong areas. A MarketSense study of 101 household brands' performance during the 1989-1991 recession showed that increased ad spending raised sales of Jiff peanut butter, Kraft salad dressing, Bud Light, Coors Light, Pizza Hut and Taco Bell. Brands that neglected marketing, on the other hand, saw their sales drop steeply: Jell-O, Hellman's, Doritos, Green Giant and McDonald's are a few examples.

    Historically, one of the safer places in the equity market is consumer staples. These are typically the last products a household removes from its budget. By contrast, electronic retailers and other consumer discretionary companies can suffer as consumers put off higher-end purchases. (See also, "Cyclical Versus Non-Cyclical Stocks.")

    That said, it's dangerous to pile into a single sector, including consumer staples. Diversification is especially important during a recession, when particular companies and industries can get hammered. Diversifying across asset classes – such as fixed income and commodities, in addition to equities – can also act as a check on portfolio losses.

  • Investing in Fixed Income in a Recession
    Fixed-income markets are no exception to the general risk aversion of recessionary environments. Investors tend to shy away from credit risk, meaning corporate bonds (especially high-yield bonds) and mortgage-backed securities, since these investments have higher default rates than government securities. As the economy weakens, businesses have a more difficult time generating revenue and profits, which can make debt repayment difficult and, in the worst-case scenario, lead to bankruptcy.

    As investors sell these risky assets, they seek safety and move into U.S. Treasury bonds. In other words, the prices of risky bonds go down as people sell, meaning the yields on these bonds increase; the prices of Treasury bonds go up, meaning their yields decrease. (See also, "What are the risks of investing in a bond?")

  • Investing in Commodities in a Recession
    Another area of investing to consider in a recession is commodities. Growing economies need inputs, including natural resources. These needs grow as economic output does, pushing up the prices for these resources.

    Conversely, as economies slow, demand slows and commodity prices tend to drop. Therefore if investors believe a recession is coming, they will sell commodities, driving prices lower. Since commodities are traded on a global basis, though, a recession in the U.S. will not necessarily have a large, direct impact on commodity prices.

Investing During a Recovery

What about when the economy begins to recover? As in a downturn, keep an eye on the macroeconomic factors. One of the tools the government uses most frequently to reduce the impact of a recession is easy monetary policy: reducing interest rates in order to increase the money supply, discourage people from saving and encourage spending. The purpose is ultimately to increase economic activity.

One of the side effects of low interest rates is increased demand for higher-risk, higher-return investments. As a result, equity markets tend to do very well during economic recoveries. Some of the best-performing stocks use operating leverage as part of their ongoing business activities, especially as these are often beat up during a downturn and therefore undervalued. Leverage may hurt during a recession, but it works well during good times, allowing firms to grow faster than companies that don't take on debt. Growth stocks and small caps also tend to do well during economic recoveries as investors embrace risk. (See also, "Operating Leverage Captures Relationships.")

Similarly, within fixed-income markets, increased demand for risk manifests itself in higher demand for credit risk, making corporate debt of all grades and mortgage-backed debt more attractive: prices go up and yields go down. On the other hand, investors tend to shift out of U.S. Treasuries, pushing prices down and yields up.

The same logic holds for commodity markets, in that faster economic growth increases demand and therefore prices for raw materials. Remember, though, that commodities are traded on a global basis, so the U.S. economy is not the sole driver of demand for these resources.

The Bottom Line

When recessions strike, it's best to focus on the long-term horizon and manage your exposures, minimizing the risk in your portfolio and setting aside capital to invest during the recovery.

Of course, you're never going to time the beginning or end of a recession to the day, but anticipating a recession isn't as hard as you might think. All that's necessary is to have the discipline to ignore the crowd, shift away from risky investments during times of extreme optimism, wait out the oncoming storm, and embrace risk when others are shying away from it. (See also, "The Greatest Market Crashes.")

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.