How Does a Recession Affect the Stock Market?

How Does a Recession Affect the Stock Market?

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While you’ll hear many explain a recession is defined as two falling consecutive quarters of real GDP, from an official standpoint, determining an economy’s recession status falls on The National Bureau of Economic Research (NBER) in the United States (US). According to the NBER, the ‘traditional definition of a recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months’. Fortunately, unlike bull markets, recessions are seldom a long-drawn-out affair; the NBER states that a recession typically lasts around 17 months, though some can be much shorter.  

Recessions can have a significant impact on the stock market, causing stock prices to fall and investor confidence to wane.

The Affect of a Recession on the Stock Market

When the US economy enters a recessionary phase, the stock market tends to observe a decline in share prices. Amid the financial crisis in 2008, stocks plummeted; according to the S&P 500—a market index that tracks the performance of 503 large US companies listed on US stock exchanges—equities sold off heavily heading into Q4 2008 and did not forge a bottom until March 2009. More recently, the COVID-19 pandemic that brought the world to a grinding halt witnessed the S&P 500 tumble approximately 20% in February and March 2020, lasting only two months before recovering and refreshing all-time highs. 

What Drives Share Prices Lower?

A common cause of lower share values is decreased corporate earnings, as businesses typically experience a decline in sales and revenue. Recessions are often accompanied by a great deal of uncertainty and consumer confidence can suffer. Logically, an economic downturn will naturally cause consumers to make cutbacks and refrain from unjustified spending, which in turn affects corporate profits. 

Higher unemployment can also drive a cutback in consumption. Ultimately, lower corporate profits can lead to lower share values and collectively put downward pressure on major equity indices, like the S&P 500 mentioned above, as well as other indices, such as the Dow Jones Industrial Average and the Nasdaq.

You may also find that during recessions, consumers and businesses have less access to credit. Banks are more reluctant to lend during economic turbulence, making it difficult for companies to raise capital and expand and for consumers to borrow and spend. All of this affects company profits and, by extension, share prices

While the major equity indices are expected to decline during a recession, some companies in certain sectors outperform, hence the need for a well-diversified portfolio to manage risk exposure. 

Impact on Different Sectors?

The impact of a recession is not evenly distributed across the equity space. As classified by the Global Industry Classification Standard (GICS), the S&P 500 is divided into 11 sectors. Information Technology holds the largest weight at 28.9%, followed by Financials at 13.0%, with Utilities controlling the lowest weight at 2.3%. 

Defensive stocks, which include companies that manufacture must-have goods—think toothpaste, groceries and healthcare—often hold their value during economic downturns. This is why you’ll frequently see these types of stocks bid in the early stages of a recession. Alongside consumer staples and healthcare stocks, utility companies can also outperform during a downturn. On the other hand, technology and consumer discretionary companies, which are considered cyclical stocks, can experience negative returns during this time, though they regularly outperform during periods of economic expansion. 

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