How to Invest in Stocks during a Recession

Recessions are terrifying.

Often riddled with fear, uncertainty, and doubt, these tough economic times challenge even the bravest of investors.

Because not only are our livelihoods at stake, but our investment portfolios are impacted as well.

For many of us, this may be our first time experiencing a recession.

Sure, the 2020 pandemic crash was “technically” a recession.

But with drastic policy measures and an influx in the monetary supply, the effects of this crash were short-lived and we soon saw record returns only a few months later.

And even for those of us who were around during the Great Recession (2007-2009), it’s been over 14 years since the last big shock to the economic machine.

But the good times are fleeting and we are now in unchartered territory.

With inflation hovering near 40-year highs, Russia’s invasion of Ukraine, a lingering pandemic, and a rapid shift in interest rates, many questions remain about where the market and the economy are headed.

Fortunately, not everything is as horrific as it seems.

Although recessions are brutal in the short run, they are oftentimes excellent opportunities to strike rich in the long run.

And with the right mindset and a sound investment approach, this could be our best opportunity yet to make millions in the market.

So with that being said, let’s explore further why you should invest in stocks during a recession and how to do it.

What is a Recession?

According to the National Bureau of Economic Research (NBER), a recession is defined as:

Loosely considered to be two-quarters of negative GDP growth, recessions are a natural progression in the economic cycle, and usually include rising unemployment, declining consumer confidence, a reduction in earnings/spending, and more.

Since 1948, there have been a total of 11 recessions, averaging out to about one every six years (the balance).

While more common than one might expect, recessions are quite short in comparison to bull runs, only making up 15% of all months in the last 70 years (Capital Group).

On average (since 1950), a recession lasts about 10 months, with the longest one being 18 months (2007-2009), and the shortest one lasting only 6 months (2020).

To date, the harshest recession of all time remains to be the Great Depression, which lasted a whopping 43 months, spanning from 1929 to 1933.

To put into perspective how bad it was, the period saw unemployment reach 23.6% and GDP drop 12.9% all in a single year.

Now that’s what I call a bear market!

But besides the horrific events of the Dirty Thirties, the key takeaway from all of this is that most recessions are fairly short.

Although they seem awful in the moment, the economy has always found a way to pick itself back up and be better than before.

For this reason, it is encouraging to know that no matter what happens in the short run, there will likely always be greener pastures just around the corner.

A Brief History of Recessions

To better understand recessions, and to see where we might be headed, it is as valuable to study past recessions and learn from their mistakes.

As the great writer, Mark Twain once said:

Here is a quick recap of the three worst recessions in the past ~100 years (based on their duration).

1. 1929 – 1933 (43 months)

The biggest economic crisis in US history, the Great Depression was largely caused by rapid expansion, reckless speculation on stocks, and relaxed lending practices in the United States during the 1920s (Roaring 20s).

When the bubble finally burst and the stock market crashed, prices went into freefall leaving investors and speculators scrambling for money.

This domino effect caused businesses to reduce production and spending, which led to mass layoffs, and eventually a run on banks.

It was not until Franklin D Roosevelt was elected and the government signed into law the “New Deal” in 1933, that things began to turn around.

2. 1920 – 1921 (18 months)

Largely in part due to the effects of WWI, government debt exploded because of wartime spending which led to inflation rates rising well above 20%.

To mitigate this, US authorities took a drastic approach whereby they cut federal spending by 65% in one year and raised discount rates to a record high of 7%.

From its peak in June 1920, the Consumer Price Index fell 15.8% over the next 12 months, far greater than what was ever experienced during the Great Depression

3. 2007 – 2009 (18 months)

The Great Recession was the most severe economic downturn in the United States since the Great Depression.

Primarily due to a lack of regulations in the financial industry, banks implemented relaxed lending policies which led to a massive surge in demand and speculation in the housing market.

Adding to the blow, banks attempted to mitigate their risk by bundling bad loans into something known as mortgage-backed securities (MBS) and selling them to institutional investors around the world.

When these loans began to soar, and unqualified borrowers defaulted on their debts, the value of these MBSs fell sharply, which caused a series of bankruptcies in the financial sector and beyond.

From peak to trough, the stock market lost approximately 50% of its value and caused an unnerving tremor that is still felt to this day.

Where are the Markets Today?

It is no surprise that we are in tough economic times right now.

But despite all that we are reading and hearing, it seems like the effects of a recession have yet to be fully realized.

Although the market has fallen 16% this year, many questions remain about where we are headed and what will happen next.

Meanwhile, multiple recession indicators are flashing red, signaling to us that the worse has yet to come.

Since no single indicator is reliable enough to predict the future, it is necessary to take all of these warnings with a grain of salt.

But with that being said, it can still be useful to analyze this data and compare it to the past.

As such, here are three of the best indicators to gauge a recession.

Who knows, they might just give you a glimpse into the future.

1. Schiller PE

The Shiller PE or CAPE ratio invented by behavioral economist Robert Shiller was created to measure the price of the stock market in relation to its inflation-adjusted earnings.

While primarily used as a stock market bubble indicator, the Shiller PE has averaged a PE ratio of 16.99 since 1870.

In its brief 150-year history, the Shiller PE has exceeded a PE ratio of 30 just three times, indicating extreme bubble territory and a massive correction to follow.

The three instances where the Shiller PE past 30 were the Great Depression (1929), the Dot Com bubble (1999), and 2021.

2. Inverted Yield Curve

Have you ever heard of an inverted yield curve?

It is a strange phenomenon that happens when long-term interest rates sink below short-term interest rates, indicating that investors are moving away from short-term bonds and into long-term ones.

Historically, an inverted yield curve suggests that the markets are becoming more pessimistic about the economy in the near future, as investors choose to sacrifice higher interest rates for greater security and stability.

Over the past 50 years, an inverted yield curve has predicted all of the past 7 recessions without fail.

Today, the yield curve is inverted with interest rates sitting at 4.22% (3 months), 3.65% (5 years), 3.50% (10 years), and 3.54% (30 years).

3. Unemployment Rate

Usually one of the strongest indicators of a recession, US unemployment remains surprisingly low, despite economic headwinds elsewhere.

Largely in part due to the pandemic, labor demand remains relatively stable given that the economy is still trying to catch up with demand in certain sectors.

Although there have been major layoffs in the tech sector recently, overall, the US Labor market remains resilient and unaffected by the broader economic slowdown.

In November alone, the US economy added 263 thousand jobs, with a large number of them happening in the leisure and hospitality (88 thousand), food services (62 thousand), and health care (45 thousand) industries.

How to Invest during a Recession

Now that we have improved our understanding of recessions, and are more familiar with the current economic landscape, it is finally time to learn how to invest during a recession.

Investing in a recession can be one of the best decisions you make as an investor because it presents opportunities to buy wonderful businesses at a discounted price.

If you can stomach some risk and are comfortable investing a large chunk of your money into your highest conviction bets, then you are likely to be in a position where you outperform the market for years to come.

Here is how to make it happen.

1. Stick within Your Circle of Competence

If you don’t understand a business, don’t buy it.

It is easy to get swept up in the hottest new stocks and industries, especially when everyone else is talking about them.

But by choosing to invest in businesses you understand well, you relieve a lot of the stress that comes with investing and reduce a lot of the risks as well.

To find businesses that you easily understand, search for those that are already meaningful to you in your daily life.

For example, this could be a business that you are a customer of or an employee of, or maybe you are just really fascinated with a particular industry (eg. I use Google’s products every day for work and leisure).

No matter what your reason is for investing in a stock, always take the time to better understand it, while also being comfortable saying “No” to any business that is too difficult.

Overall, the better you understand a business, the more comfortable you will be buying its shares, even if it is down 50% since your last purchase.

2. Buy Great Businesses

Picking the winner always feels great, but it is important to distinguish that this has nothing to do with how the stock price performs.

Instead, shift your attention towards the fundamentals of a business and focus on those that possess a durable competitive advantage within their respective market.

To do so, consider things like a business’s brand strength, cost structure, network effect, proprietary data, and more.

In addition, investigate the company’s financial statements and determine whether the business is consistently growing its top and bottom line over the years, and has little debt on its balance sheet.

A company with healthy and predictable financial statements, and a clear business model, is usually a strong sign that they are capable of overcoming any headwinds caused by a recession.

By only investing in the best businesses, you ensure that your money is well protected and is likely to continue growing, even when the rest of the market is heading oppositely.

3. Bet on the Jockey

Investing in companies where the management team is closely aligned with its shareholders is a must during a recession.

Since you are buying a piece of this business, you want a CEO that is transparent and accountable to shareholders and is also comfortable making tough decisions, like cutting costs, when needed.

To find managers that are closely aligned with their shareholders, look for management teams that have a large portion of their personal net worth invested in the company.

Also, review the company’s annual letters to determine whether the CEO is sincere in their communication to shareholders and whether they execute all of the objectives they promised in the past.

Lastly, calculate a company’s return on invested capital (ROIC) to see how effectively they are allocating capital and reinvesting cash back into the business.

A business with a growing ROIC or one that is consistently above 10% every year, is a good indication that a management team knows what they are doing when it comes to growing the business.

Ultimately, you want to find managers that are both intelligent and honest because when the going gets tough, it is important to know that your money is in good hands.

4. Buy Stocks with a Margin of Safety

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Lastly, and most importantly, you want to buy businesses when they are trading at a discount to their intrinsic value.

Typically, the stock market is the only place where shoppers buy at a premium and sell at a discount.

We need to flip this framework upside down and hone in on businesses that we can buy for cheap, without sacrificing the quality of the business.

By buying businesses on the low, not only do you realize better returns, but you also protect your downside in the process because the stock has less room to fall.

To find undervalued stocks during a recession, measure a company’s average historical P/E ratio to its current one, and compare it to the other players within the industry.

If a wonderful business’s current P/E ratio is below that of its peers and its historical price point, this may be a great sign that the business is undervalued.

Although there are more complicated methods for evaluating the price of a business, using a company’s P/E ratio is a simple way to improve your understanding of what a business is worth, without having to do much work.

All-in-all, if you focus on buying excellent businesses, with honest managers, at a discounted price, you should set yourself up for great success when the next recession comes.

Disclosure/Disclaimer:

We are not brokers, investment or financial advisers, and you should not rely on the information herein as investment advice. If you are seeking personalized investment advice, please contact a qualified and registered broker, investment adviser or financial adviser. You should not make any investment decisions based on our communications. Our stock profiles are intended to highlight certain companies for YOUR further investigation; they are NOT recommendations. The securities issued by the companies we profile should be considered high risk and, if you do invest, you may lose your entire investment. Please do your own research before investing, including reading the companies’ public filings, press releases, and risk disclosures. Information contained in this profile was provided by the company, and extracted from public filings, company websites, and other publicly available sources. We believe the sources and information are accurate and reliable but we cannot guarantee it. The commentary and opinions in this article are our own, so please do your own research.

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