Financial markets, like nearly every other market, prefer economic growth to recession. The characteristics often associated with recession, such as lower profits, higher unemployment, less investment and general uncertainty, are not conducive to asset price appreciation. That said, it is very difficult to predict exactly how the broader financial markets are going to react to a downturn. To understand how the overall performance of financial markets might be impacted by a recession, consider the underlying structure of each. By focusing on the most important variables, it is possible to get a general sense of action and reaction.

How Financial Markets and Recessions Are Formed

It is important to break down recessions and financial markets into their base components. A financial market is not a congruent and stable entity that pursues objectives of its own; rather, financial markets are where buyers and sellers of specific goods trade. When the sum of those goods grows in price, the financial markets are said to be rising. Conversely, when those goods lose value on net, the markets are falling.

There are thousands, if not millions, of individual actors inside the financial markets at any one time. Not all of them have the same holdings, objectives or strategies. Not all of them are going to react to a recession in the same way. The securities and other assets of some traded companies tend to rise when times are tough, while others tend to lose value. It is important to recognize that the stock market and the broader economy are related but not mutually determinant.

Recessions can be thought of as a general cluster of business errors. Economists disagree about the nature and causes of recessions, but the effects of a recession are brought about because business errors are realized simultaneously. Faced with incorrect forecasts and financial loss, businesses need to reorganize resources and put them toward more valuable and productive ends. This often means reorganizing labor and creating unemployment. The subsequent unemployment causes a drop in total spending and investment. Production slumps and prices tend to drop.

How Business Errors Affect Investment Asset Prices

During recessions, businesses are compensating for forecasting and operating errors. Oftentimes, the value of the business and all of its assets drops as a result. Some businesses completely fail and close their doors. Investors in these businesses see the value of their stocks drop. Faced with possible capital losses, investors normally look to escape riskier assets and move into less risky holdings. This flight is typically manifested in declining stock market values.

Investors make errors leading up to a recession as well. Many incorrectly assume their holdings will continue to deliver returns. Too much risk is assumed in the ex-post sense. To limit exposure to added loss, investors choose to keep their money "on the sidelines" until profitable opportunities are spotted.

Not all business sectors are equally affected in a recession. Not all investment assets are equally affected either. Recession and financial market are two broad terms, but that does not mean they ought to be examined as dynamic actors. It is more accurate and useful to understand that business errors sometimes result in capital losses.

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