How Can I Be a Smart Investor During a Recession?

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The most straightforward way to invest smartly during a recession is to take advantage of the panic and mass-selling and buy now low-priced shares of blue-chip and high-quality companies that you know will ride out the recession. It can be easy to buy too early, however, and lose when the market continues falling. One way that more risk-tolerant and sophisticated investors can profit even during the bear market is with investment products that go up in price when stock prices fall. These include short stocks, inverse ETFs and put options, to name a few. We will discuss the difference between these types of downward-looking investments and the risks and advantages of each. 

What is a recession?

To start off, what is a recession? Economists generally define a period of recession as when an economy has experienced two consecutive quarters of negative gross domestic product (GDP) growth. They are an unavoidable part of the economic cycle and are often associated with bear markets and significant drops in stock prices as investors panic and worry about the health and earnings of businesses.

To better understand how a recession fits in an economic cycle, one should know that economies are generally cyclical and go through 4 phases: expansion, peak, contraction and trough.  

Economic expansion refers to the growth phase of the economy where production is increasing and GDP is rising. A Goldilocks economy can remain in the expansion phase for a pretty long time. Economies are not perfect machines and will often overshoot their natural growth rates, causing inflation and increased prices. While inflation can be controlled by central banks by increasing the benchmark rate, this excess is unsustainable and will eventually peak. A contraction follows and is characterized by a fall in GDP growth and rising unemployment. If the contraction continues, a recession can occur. At this time, central banks will often lower interest rates in order to promote growth. Finally, the economy reaches its lowest point in the trough phase and begins to recover, starting all over again with expansion.  This cycle typically lasts less than 10 years.

What are the best investment strategies for a recession?

The best investment strategy for a recession is one that was started before the start of the economic decline and continues during and after the recession. This way, the strategy can take advantage of the shifts in market sentiment and earn a high rate of return. 

Before (or at the start of) a Recession: 

Strategy: Short the market by buying inverse ETFs or put options. Diversify with fixed-income.

Shorting the market

One way to profit from a bear market is to short the market.  Shorting the market basically means you profit when the price of an underlying asset (most commonly a stock or ETF) goes down. You borrow an asset and sell it at the current price, and buy it back later when the price is lower, earning the differential in the process. Today’s top trading brokerages make it a very simple and straightforward process. However, because of the possibility of unlimited loss when the price of your borrowed asset goes up,  many investors may prefer other investment products to emulate shorting the market.

Inverse ETFs

Inverse Exchange Traded Funds are another way you can short the market while minimizing the risks from a direct short. They track a certain underlying index, which can be made up of different stocks, bonds, or commodities, and increase in value when the price of their index goes down.  With leveraged inverse ETFs, the return could be two or even three times of the index’s change in price. E.g if the market goes down by 2%, a leveraged inverse ETF can go up by up to 4% (-2X) or 6% (-3X). This leverage does come with additional risks, especially during periods of volatility, and are not recommended as long-term investments.

The main advantage of inverse ETFs in comparison to a direct short is that the maximum possible loss would be the amount you invested as the price of the ETF cannot go negative. Still, they should be used mainly to capture downward movements in the market, like during the early stages of a bear market when there is mass panic and selling, and do not perform as well in periods of high volatility.

Put options

A put option is another product (an equity derivative) that can increase in value if the market goes down. Put options holders have the right (but are not obligated) to sell a certain amount of an underlying security at a particular price and within a specified time frame. For example, if I buy a SPY 04/17/2020 put option at $240, I have the right to sell 100 shares of SPY at $240 to the person who sold me the put option at any time until and including 04/17/2020. These are called American-style options, and there are European-style options that, rather than allowing you to use them at any time, can only be used at a specific time on their specified date. Put options generally increase in value as the underlying asset price declines, lose value over time, and are available on a wide range of assets. They are however quite complex and risky to invest in.

Fixed-income products

Risk-averse or conservative investors can invest in fixed income products. Investors are paid a certain interest rate until the investment’s maturity date and at maturity, the principal amount is repaid. Examples of well-known fixed income products are government or corporate bonds, fixed income ETFs, certificate of deposit (CDs) and mutual funds. 

Because fixed-income products give you the principal back at the end of their term, they tend to be seen as safe investments. Due to this perceived safety, however, they also tend to have lower returns and low interest rates. During a bear market, fixed-income products tend to increase in value as their security becomes more and more highly-valued. Subsequently, diversifying your portfolio with fixed-income can help protect your portfolio against recessions. 

During and near the end of a recession: 

Strategy: Buy real estate in high demand areas or undervalued stocks

The middle of a recession can offer you immense real estate opportunities. This is the time to buy real estate in high demand areas – if you can get a good price. During the Great Recession of 2008, you wouldn’t have saved money if you bought a property in areas like Manhattan and certain areas of Boston where prices didn’t go down. However, there were significant sales available elsewhere that were much cheaper than before the recession. This means you might have to compare real estate prices in different areas to those before the recession to ensure you get a good bargain. 

Also, close to the end of a recession, you might want to look for solid stocks that have had their prices drop due to the bear market. Prices will typically go up as the recession ends, especially when central banks pump money into the market. This is currently being done by central banks worldwide in response to the COVID-19 pandemic. You can read more about the Bank of Canada’s response in our guide.

You should be prepared to wait for up to 3 years for these stocks to return back to previous highs, but based on previous recessions, you can expect up to a 50% return on your investment. If you are a risk-averse investor, it might be best to invest in Exchange Traded Funds and track indices and diversified baskets of assets rather than betting on a single company.

This is also the time to sell your fixed-income products. They would likely have increased in price, and at their current prices would yield very low returns. You can use that money to invest in stocks instead and potentially earn a much higher return on your investment.

Conclusion

The best investment strategy for a recession is one that is done over time and dynamically according to the market’s condition. As a recession looms, consider buying inverse ETFs. If you are a highly sophisticated and experienced investor, then you might consider leveraged inverse ETFs or even buy put options on stocks and indices, especially on companies that you think will be the most affected. The middle of a recession offers you an unparalleled opportunity to invest in the real estate market at low prices and as a recession ends, buying and holding on to solid stocks is a wise investment choice since they will continue to earn money and grow after the recession.

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