What Happens to the Stock Market During a Recession?

It's no surprise that people are concerned about the possible effects of a recession, given the pressure inflation is putting on household budgets in the United States. The National Bureau of Economic Research has not officially declared the U.S. to be in a recession.

Fears of a possible recession have circulated for more than a year. Everyone will be curious to see how their financial situation will change if those fears come true.

Explore what happens to the market during a downturn and how it might affect you.

The Key Takeaways

Prepare for a possible recession by building savings, paying off debt and improving your investment strategy.

What Happens To The Stock Market During A Recession?

Stock market returns are usually in the red when the economy is in a recession. In the 2008 recession for example, the S&P 500 returned 38.5%.

The stock market does not always follow the same pattern. S&P 500 returned 16.3% for the 2020 recession. The stock market had some impressive returns during that recession.

Only time can tell what the future holds for the stock market.

Inflation and its Chain Reaction

In 2021, the fear of a possible recession grew when inflation rates reached levels not seen since 2008. People began to worry about a recession in 2021 as the annual inflation rate reached levels not seen since 2008.

The Fed's main tool for controlling monetary policy is interest rates. The Fed can influence the rate that banks lend cash to each other by raising the federal funds rate. The amount of cash that banks keep on hand is tied to specific reserve requirements. When the cost to borrow money increases, this encourages them to save.

Interest rates on savings accounts also start to rise when inflation is high. The banks do this to encourage people to deposit money in their accounts.

Bond yields increase when interest rates rise. Bond yields that are higher make the yields of existing bonds appear lower, which drives down their price in the secondary market.

Consumer borrowing costs increase, and discretionary spending falls. Businesses stop growing at the same rate. It's good for prices, as the reduced demand allows for lower prices. However, it could be risky for an economy. It's possible that companies may start to lay off workers as demand drops. Demand can be further lowered.

Investors withdraw their money from the stock market. The drop in demand damages profits for corporations, and the optimism about the economy dwindles. The Fed must walk a thin line between reducing inflation and causing the economy to enter a recession. The Fed would like to achieve a "soft landing" where the inflation drops without a recession. However, it can be difficult to do.

How will a recession affect me?

Investors are on edge when a recession is looming because of the unpredictability, and the potential for large losses. It's no secret that a recession is not a pleasant experience for the majority of people. In fact, it affects everyone involved in the economy.

You'll typically see your portfolio drop during a recession. Stock values are dropping partly due to massive sales as investors attempt to exit the market.

Stock prices drop as more investors sell shares. As more investors become scared and start selling their portfolios, this can spiral into a downward spiral. Stock prices can fall even for companies that are well positioned to weather the new economic climate.

Sadly, many investors' portfolios lose significant value when a recession hits. This is particularly true for investors that choose to sell their portfolios, which effectively locks in their losses.

Many experts recommend focusing on the future to avoid major losses. Look at your overall portfolio plans instead of trying to prevent the fall.

It's important to regularly review your portfolio goals before a recession. Rebalancing your portfolio regularly and keeping a long-term perspective will help you avoid panic selling.

A recession will have a significant impact on your finances, and not just the stock market. Some businesses cut workers as the economy slows. You may be able to survive the recession if you have saved enough money.

Recessionary Fears in 2022

For several reasons, many people were worried about a possible recession in 2022. The Russian invasion in Ukraine created worldwide economic uncertainty, and an energy crisis was created in Europe. As many countries boycotted Russian energy, gas prices rose. Investors were also more cautious about investing in risky assets because of the global conflict.

In 2022 the rate of inflation reached a frightening level, peaking at 9.1% annually in June. The Consumer Price Index was high due to high oil, food, and housing costs. The Fed also led a rate-hiking campaign that pushed mortgage rates up to historic levels.

Last year, corporations saw their revenue numbers plummet. Layoffs and reduced spending were the main headlines. Investors had a pessimistic outlook for the year as they saw cryptocurrency exchanges collapse, the biggest-ever outbreaks of avian influenza, and layoffs in the tech industry.

Recessionary Fears in 2023

Investors seem more optimistic this year, even though most experts still predict that the NBER will declare a recession by 2023. Analysts expect the Fed to continue its rate-hiking campaign for a few more increases before rates begin to drop.

The annual inflation rate has also decreased, to only 5.0% by March 2023. This is still above the Fed's target of 2%. The campaign could continue if their next rate increase doesn't produce the desired results.

Bitcoin's value, which plummeted from more than $60,000 in 2020 to less than $20,000 in 2022 has recovered in the first few months. This price increase may be partly due to the recent collapse of Silicon Valley Bank, which caused investors to express their skepticism about centralized banking.

How to Prepare for Recession

Prepare for a possible recession to avoid financial hardship. The preparations you should make will depend on your specific situation.

You can prepare your home for a storm by following these tips.

Create an Emergency Fund

Experts recommend that you maintain an emergency fund large enough to cover 3 to 6 months' worth of expenses. These funds can help you survive if you are faced with unexpected expenses or lose your job.

If, for example, your employer fires you unexpectedly and your child breaks their leg on the way home from school one day, you will need to use your emergency fund to pay medical bills.

Reduce Debt

Your finances can suffer if you have a lot of debt. Monthly payments can add up quickly. Pay off debts with high interest rates first, if possible. This is referred to by financial experts as the "snowball" method. If you are prone to forgetfulness, it is helpful to set up automatic payments from your monthly paycheck.

Buy only what you need

Consider delaying a major purchase until you have more information about the state of the economy. You might choose to wait to buy a new vehicle if your old one is still safe.

How to Invest in a Recession

A recession offers investors a variety of options. Some investors may panic and liquidate their investments. Some investors view a recession as a great opportunity to buy at a discount.

The best approach will likely be somewhere in the middle. Some investors choose to invest in index funds, while others like to make changes on the spot.

Don't forget that not all industries will be affected equally by a recession. Stocks for discount retailers and utility companies as well as grocery companies are relatively stable in a recession because their products remain essential.

Changes in market conditions will have an impact on your portfolio. Monitoring various economic indicators will help you to make the necessary adjustments.

It takes a lot of time and effort to stay on top these indicators. As technology advances, people are finding ways to outsource the sometimes-difficult task of managing a portfolio to an AI powered portfolio.

The Bottom Line

Stock market returns drop hard during a recession. Some may also lose their jobs during a downturn, in addition to their portfolios. Many publications and individuals predicted that the NBER will call a recession earlier rather than later in 2022. Many experts believe it will occur later this year, even though they have not yet called it.

To prepare for a possible recession, you can make yourself more indispensable to your team to avoid being fired. You can build an emergency fund, and pay down debt.