When the media starts reporting higher interest rates and spiraling price rises, their next story will almost certainly scream the impending doom of a possible economic recession.
What exactly is a recession and is it all bad news for local share market investors?
Most commentators believe a ‘technical recession’ occurs when there have been two consecutive quarters of negative growth in real gross domestic production (GDP) or economic output, but there really is no strict definition. It refers to a time when unemployment increases and growth falls.
A recession can last just a few months, or it can drag on for years, depending on economic conditions. So, for example, in mid-2020 economic output plunged by 7% in the June quarter and unemployment jumped to 7.5% as the pandemic hit but then the economy quickly bounced back in the following September quarter as the Federal Government stepped in with financial support.
Typically, most economists expect a true recession to last several years, as it did during the so-called ‘recession we had to have’ in the early 1990’s and the mining collapse recession of the early 1970’s.
What is interesting though is that share markets usually perform quite well during recessionary periods. The very long and very damaging drought-induced recession from 1981 to 1983 prompted the Australian share market to post its best ever calendar year. It achieved a 60% gain at a time when the economy felt like it was coming to a standstill. This happens because investors are typically spooked by the idea or the prospect of a recession occurring and so they start to sell their shares early, and in doing so, put downward pressure on prices.
What causes prices to fall is the fear of a recession, not the actual recession itself.
Share markets tend to rebound as the headlines talk of corporate layoffs and bankruptcies. Investors then start to be tempted to buy shares at their new lower prices in anticipation of profits improving as the economy invariably moves out of recession and by doing so, they push share prices higher. Share prices generally fall before economic contractions start and then start rebounding while economies are still contracting. Some believe the Australian share market has already fallen as far as it is likely to go during this economic cycle, simply due to increasing interest rates, lower consumer spending, and softer company profits already being factored into most company share prices.
As Warren Buffet says, “When stocks are down, we’re going to be buying on balance, and who wouldn’t rather buy at a lower price than at a higher price?”
Given this, the very worst thing any share market investor can do is panic and sell their existing shareholding on the fear prices will only fall further. This effectively crystallises your losses and means you will be out of the market when it does recover.
However, prevention is better than a cure. Keep in mind that stocks are long-term investments. If you’re expecting a return in less than two years, stocks are probably not for you. Ideally, you should be aiming for decades-long growth. There are key steps you can take to help recession proof your portfolio. Get educated on what you are buying. Diversify your shareholding across several sectors for example, as it is unlikely all sectors will be hit equally badly during tough times.
Avoid small, high-risk companies. Look for large, well-managed companies with a proven track record of doing well in good times and in bad and which have a very easy to understand way of making money.
Look for high dividend paying stocks as this income is likely to continue even when times get tough, and the market pushes their share price lower. While dividends may also fall during tough times, a company that continues to pay out income to its shareholders will always have some value.
Market downturns also present great buying opportunities for investors.
Seek out companies with solid underlying businesses that for whatever reason are being marked down by the market. They could present good buying opportunities.
Another useful strategy is dollar-cost averaging. This is where you set a budget to invest a set amount of money every month or quarter. In doing this, you will always be buying more shares when prices are lower and less when prices are higher.
Remember all economic downturns come to an end eventually and good times will return. If you are concerned about your situation, speak with a qualified financial planner to better understand what you should be doing should Australia be hit by a recession.