Rule #1 Finance Blog

With Investor Phil Town

What Is A Recession? How Should We Prepare?

Recently, there’s been endless debate over whether or not the U.S. is on the brink of, in the early stages of, or is officially in a recession. The recession probabilities are endless.

Many economists argue that the signs and indications of recession are clearly evident, while others say more qualifiers and economic research are needed to make a final call. 

What we do know is recessions are not uncommon. They are a natural part of the economic cycle. 

In fact, many consumers are still reflecting on lessons learned from the brief recession that began in February 2020 and lasted until April 2020 as a result of the COVID-19 pandemic.

Though this was the shortest recession in U.S. history, its effects were felt around the world, throwing a wrench into the global economy and feeding fears over another looming financial crisis. 

What’s important to remember is recessions happen, and often don’t come on suddenly. The best way to prepare for any period of an economic downturn is to educate yourself on best practices for navigating this business cycle and keeping a watchful eye on the money supply.

So, what is a recession?

Let’s discuss this further so you know what causes recessions, the warning signs that one is coming, and how you can protect your finances when it hits.

What is a Recession? 

Many people can feel confused about what defines a recession since the definition from the National Bureau of Economic Research is broad. 

The National Bureau of Economic Research is typically recognized as the authority that defines the start and end dates of all U.S. recessions. According to NBER’s definition, a recession is: 

“A significant decline in economic activity that is spread across the economy and that lasts more than a few months.”

Building off of the National Bureau’s definition, let’s create our official definition. 

Simply put, a recession is a period of an economic downturn that can span a few months to even a few years and is characterized by a declining GDP. 

When the real GDP—the inflation-adjusted, total market value of all goods and services produced within an economy—drops in two consecutive quarters, a recession could be around the corner.

There are also a number of other considerations that factor into the decision to define a period of decline as a recession and these include rising unemployment, reduced consumer spending, and limited industrial production.

Understanding Recessions

Though recessions are a normal part of the business and economic cycles, it’s scary to see the word and its negative connotations being thrown around. 

We get the impression that all things negative—negative growth, negative GDP growth, a decline in economic activity, economic downturn, etc.—are the only things that come out of a recession. 

But, the truth is, recessions are necessary. 

We just need to understand them a little better in order to effectively monitor and manage our finances when the economy shifts, and look forward to the period of economic recovery which we will inevitably enter after any period of significant decline.

What Causes Recessions?

There are a number of different changes in economic activity that can trigger recessions. From sudden economic shock to technological changes, what causes a recession varies. 

However, economists agree that these are some of the biggest culprits:

Sudden Economic Shock 

Think of economic shock as the surprise event that brings financial crisis with it everywhere it goes. 

when will the stock market crash

Looking back on the most recent recession, the COVID-19 pandemic is an example of an extreme event that caused a global recession and put the International Monetary Fund on high alert. 

This led the International Monetary Fund to reevaluate general monetary policy and compile a list of responses from individual nations about their intentions for navigating this financial crisis.

Excessive Debt

When businesses or individuals take on more debt than they are able to pay off, this can cause the economy to fall on hard financial times. 

If these bills are left unpaid, excessive debt and bankruptcies can run rampant until it upends the economy and leads to recession.

Asset Bubbles

Asset bubbles are the product of poor investment decisions. When the economy is strong, investors want to capitalize on exceptional market value and some start making investment decisions based on emotional instinct instead of logical reasoning. 

This type of behavior has been coined by Former Fed Chair Alan Greenspan as “irrational exuberance.” 

Unfortunately, this type of economic activity inflates stock market and real estate bubbles, which will eventually burst, lead to panic selling, crash the market, and result in a recession.

High Inflation

When the prices of goods and services continue to increase over a specific period of time, inflation occurs. If monitored and checked, inflation is not necessarily worrisome. 

Impact of inflation

However, rapid and unrestrained inflation, known as hyperinflation, can lead financial institutions—like a central bank—to raise interest rates. Higher interest rates discourage consumer spending, which can then lead to recession. 

In the past, the Federal Reserve has combated the damaging effects of hyperinflation by raising interest rates, which, again results in a prolonged economic downturn.

Deflation

Too much deflation, or the decline in the cost of goods and services over time, can also cause concern because it’s often a sign that wages will begin to stagnate. Naturally, this then leads to reduced consumer spending, which can hurt the economy. 

Thankfully, in most instances, many central banks and economists usually step in to help regulate how to manage excessive deflation before it gets out of hand.

Technological Change

It seems as though there are new technological advancements and breakthroughs made every day and it can be hard to keep up. 

Though this is beneficial because it can increase productivity, there is a necessary adjustment period where operators must familiarize themselves with how to utilize these new devices and systems to maximize efficiency. 

Not to mention, the invention of new products can automate processes in certain fields, reducing the number of workers needed to perform specific jobs and ultimately leading to job layoffs. 

High unemployment is often one of the common signs of recession, which is something we’ll cover in more detail in the next section.

Signs of a Recession

When taking a closer look at determining whether or not we’re in a recession, there are many factors to consider. 

We know the economy must be trending downward for two consecutive quarters, however, there are more common warning signs that a recession is coming (or has already arrived) that you should be aware of.

Inverted Yield Curve

Economic research from the Federal Reserve shows that an inverted yield curve is one of the strongest predictors that a recession is coming, citing that every U.S. recession in the past 60 years was preceded by one.

Essentially this type of curve shows us that a short-term U.S. treasury is paying higher interest rates than a long-term treasury. 

When we’re experiencing a period of economic expansion, yields should be higher on long-term bonds, but when the opposite is true, and long-term yields are lower, many economists begin to keep an eye out for a recession that could be on the horizon.  

Declines in Consumer Confidence

When consumers start to take on a fear mindset and no longer feel as comfortable spending with confidence, this could be a sign that a recession is near. 

Consumer spending is what feeds economic growth. Without it, the U.S. economy could begin to slow down. 

Drop in the Leading Economic Index

The Leading Economic Index (LEI) was designed to predict the future economic activity spread. 

It takes applications for unemployment insurance as well as new orders for manufacturing and stock market performance into consideration in its calculations. 

If there is a decline in LEI, it is an indication that the economy might be in a rocky spot.

Sudden Stock Market Declines

If the stock market suddenly and unexpectedly declines, economists will take this as a sign that a recession is near because traditionally, investors will begin to sell if they do not view the current business cycle as an opportunity for investment growth. 

Rising Unemployment

The unemployment rate can impact the way we perceive the health of the economy. 

If employment is high, that means that there is work that needs to be done in order to sustain the production of goods and services and meet consumer expectations. 

But, if employment is low, it’s likely there’s no longer a need for workers in specific fields, so steep job loss occurs. This is a telltale sign that a recession is coming in the future.

Rising Housing Prices, Rates, and Oil

These are just a few other costs that tend to spike in the midst of or right before a recession strikes. Asset prices, including the costs of gas and food items, also tend to creep up.

What’s unique about our current situation is the strength of the job market. This employment boom is one of the strongest in our country’s history. 

However, it’s also important to keep in mind that some of the data that corresponds to the strength of the market could be correlated with the fact that numerous workers have decided not to return to work as a result of the COVID-19 pandemic.

On the flip side, we’re experiencing a handful of the signs listed above. We’re seeing negative GDP growth, which is contributing to rising inflation and perhaps a period of “stagflation.” 

Wholesale retail sales are on the decline as well since there’s been a drop in consumer demand, so consequently manufacturers are producing less. 

It can also be expected that this negative economic growth seen in the second quarter will impact employment in the third quarter and fourth quarter of this year. 

Despite all of these signs, it’s important to recognize that the Federal Reserve is tightening up interest rates with the intention of stopping inflation, but in order to do so, they’ll have to shut down a part of the economy.

How Long Do Recessions Last?

So how long should we generally expect recessions to last?

On average, the National Bureau of Economic Research estimates that recessions typically last just under two years (about 21.6 months). 

Over the last 30 years, the United States has experienced four major recessions. These include:

  • The Covid-19 Pandemic: This is the most recent recession in U.S. history, which was caused by the unexpected outbreak of the coronavirus pandemic. As mentioned, the NBEC declared a brief recession that lasted from February 2020 to April 2020. 

Although the GDP fell by more than a percentage point, the 5.1% decline in the first quarter of 2020 and the 31.2% decline in the second quarter of 2020 were not enough to make this recession last long.

However, this decline still caused high unemployment and deflated consumer confidence, reducing spending to essential items only. 

  • The Great Recession: Prior to the COVID-19 recession, the last recession the U.S. experienced was the Great Recession in 2008. Although not as extreme as the Great Depression, which takes the cake for the most significant decline in economic activity, the Great Recession is a close second.
  • The Dot Com Recession: The U.S. economy experienced another turbulent period from March to November 2001. It occurred right after the tech bubble crash and coincided with the 9/11 attacks on the World Trade Center, which temporarily affected the economy’s growth rate.
  • The Gulf War Recession: Once Iraqi troops invaded Kuwait in the early 1990s, the Gulf War officially began. This attack led to lower rates of oil production, which caused U.S. oil prices to rise and contributed to the onset of an eight-month recession.

Recessions vs Depressions

Recessions and depressions both take a toll on the economy. However, there are some key differences to consider in determining how much each one impacts economic growth. 

Both are periods characterized by employment troubles and declines in GDP for at least two quarters, but the real differentiator is the overall impact that each has on the economy. 

Recessions are generally shorter in length and their impact is not felt quite so deeply. Whereas, depressions can last longer—think years instead of a few months—and their impact on economic growth can be staggering. 

In fact, the effects of a depression could linger for years, like with the Great Depression.

The Great Depression was viewed as a significant decline in economic activity that lasted from 1929 to 1933, and the economy didn’t fully recover until after the end of World War II.

The Great Recession, on the other hand, lasted about 18 months and the damage to the economy was far less. Unemployment topped off at about 10% during this recession versus the 25% that it hit during the Great Depression.

How to Prepare for a Recession

So, now that we’ve answered what is a recession, the next question you probably have is “how can I prepare for a recession?” Here’s where you can start: 

  1. Set money aside. The best thing you can do is to begin setting money aside. Having a real income that you can fall back on in case of an emergency will be absolutely critical at this time.
  2. Decrease your spending. Take a look at your expenses and find ways that you can cut back on purchases that are not essential. In doing this, you create more flexibility and you have more funds at your disposal in the event that you need to put them toward various unexpected expenses. In addition, decreasing your spending could also help reduce inflation.
  3. Stay calm. Though this is fairly self-explanatory, your monetary policy is always better off when you make decisions from a calm, rational place. If you remain level-headed, it will be easier to make beneficial adjustments to your financial habits and investment goals if necessary.
  4. Continue investing. Lastly, it’s important to continue investing. As long as you take the time to do economic research and stay informed about investment opportunities, you can keep working toward securing the financial freedom you desire.

Investing in Wonderful Companies

Two-quarters of a downturn should not be enough to affect the way you continue to manage your investments. There are smart strategies for how to invest during a recession that you can follow to maximize your success and keep your money safe.

In fact, some of the best things to invest in during a recession are wonderful companies. During these two quarters where the economy is a bit volatile, you want to make sure you are focused on owning stocks that have real value. 

Essentially, this is any item that will benefit from inflation. At Rule #1, we suggest that this investment has a big moat and is guaranteed to thrive in an inflationary market.

Lastly, remember to exercise patience during this uncertain time. If we enter a recession, know that we will also make it out of the recession. Just because we have two consecutive quarters of decline, does not mean that we will never recover. 

History has shown that recessions always end.

Remain hopeful about the opportunities that the path to economic recovery will bring, and remember that we will all be walking that road together.

Protect Your Wealth Today

Knowing how to invest during a recession doesn’t have to be complicated. In fact, by following a few simple Rule #1 strategies, you can build a crash-proof portfolio strong enough to withstand the next market crash.

If you haven’t already, download The Ultimate Stock Market Crash Survival Guide to learn the major signs of a stock market crash, craft a survival strategy to keep your money safe, and use our checklist to carefully select recession-proof companies to invest in.