During a recession, investors need to act cautiously but remain vigilant in monitoring the market landscape for opportunities to pick up high-quality assets at discounted prices. These are difficult environments, but they also coincide with the best opportunities.
In a recessionary environment, the worst performing assets are highly leveraged, cyclical and speculative. In these conditions, risk is rejected and chances of bankruptcy are increased.
Highly leveraged companies have huge debt loads on their balance sheet. Interest payments remain constant while the recession brings a decrease in revenue, increasing the risk of bankruptcy. Cyclical stocks are tied to employment and consumer confidence, which are battered in a recession. Speculative stocks are richly valued based on optimism among the shareholder base. This optimism is tested during recessions, and these assets are typically the worst performers in a recession.
On the other hand, counter-cyclical stocks do well during recessions. This group is composed of companies with dividends and massive balance sheets or steady business models that are recession-proof. Some examples of these types of companies include utilities, consumer staples and defense stocks. In anticipation of weakening economic conditions, investors tend to add exposure to these groups in their portfolios.
Once the economy is moving from recession to recovery, investors should adjust their strategies. This environment is marked by low interest rates and rising growth. The best performers are those highly leveraged, cyclical and speculative companies that survived the recession. As economic conditions normalize, they are the first to bounce back. Counter-cyclical stocks tend not to do well in this environment; instead, they encounter selling pressure as investors move into more growth-oriented assets.