Investors should tread carefully during a recession, but they should also keep a sharp eye out for bargains on high-quality assets. This is where the greatest challenges lie, but also the greatest rewards.
High-leverage, short-term, and speculative investments tend to fare poorly in economic downturns. Investors should be wary of companies in any of these sectors because of the high probability of insolvency.
The opposite is true for those who want to weather a recession and even profit from it: they will put their money into stable businesses that have a history of thriving in downturns and have strong financials, low debt, and a steady stream of cash flow.
KEY POINTS
- Highly leveraged, cyclical, or speculative companies present the greatest risk of underperformance during recessions and should be avoided by most investors.
- When the economy is down, it’s best to put your money into well-run businesses with healthy balance sheets, solid cash flow, and low debt.
- Stocks that are considered countercyclical tend to rise in value during economic downturns.
- Utilities, consumer staples, and discount retailers are examples of industries that tend to fare well during economic downturns.
Types of Stocks with the Biggest Recession Risk
During a recession, it can be just as important for an investor to know which assets to avoid as it is to know which companies make good investments. Companies and assets that are highly leveraged, cyclical, or speculative pose the greatest risk during a recession.
A quick look at NASDAQ and what the listing requirements are
Highly Leveraged Companies
Most investors would be wise to stay away from highly leveraged firms with massive debt loads during economic downturns. Such businesses frequently struggle under the weight of excessive interest payments, which causes a DE ratio that is unsustainable.
These businesses are already struggling to make their debt payments, and the revenue decline that the recession has brought about doesn’t help. Companies in this position have a greater risk of failing (or at the very least experiencing a dramatic decline in shareholder value) than do those with lower total debt loads.
IMPORTANT
When an economic recession occurs and lending standards tighten, businesses that have taken on more debt are at greater risk.
Cyclical Stocks
When the economy is in a downturn, cyclical stocks tend to suffer because they are so closely linked to factors like employment and consumer confidence. When the economy is booming and people have more disposable income to spend on luxuries, cyclical stocks tend to do well. Companies that produce luxury goods such as automobiles, furniture, and clothing are good examples.
However, when the economy is struggling, people tend to reduce their spending on things like entertainment and dining out. They cut back on expenses for vacations, eating out, and entertainment. As a result, cyclical stocks in these sectors tend to underperform and lose their appeal to investors in a down economy.
Speculative Stocks
The high price of speculative stocks is a direct result of the optimism of their investors. These assets typically perform the worst during economic downturns, putting this optimism to the test.
Investors looking to get in on the ground floor of the next big investment opportunity often look to speculative stocks, which have not yet proven their value, as an opportunity.
It is common for these high-risk stocks to fall the most rapidly during a recession, as investors flee the market and seek out safe-haven investments that reduce their risk exposure.
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Stocks That Often Do Well During Recessions
The temptation to stay out of the stock market during a recession is strong, but doing so could cause investors to miss out on lucrative opportunities. In the past, there have always been businesses that thrived in bad economic times.
To mitigate the effects of a recession, investors could implement a strategy centered on countercyclical stocks with solid balance sheets operating in recession-proof sectors.
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