Recession Primer, Part One: The Basics of How, Why and When

David Frost // How To Invest, Market Outlook


February 23  

A recession is an economic downturn or a period of general economic weakness. Of course, every economy in the world has its ups and down, but a downturn isn’t considered a recession until it has lasted several months, usually for at least two straight quarters. In this series, we’ll discuss what makes a downturn a recession, what signals to watch for, and what the Federal Reserve does about them.  

What does a recession look like?

In the U.S., the National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” In layman’s terms, a recession occurs when overall spending in the country drops significantly as consumers either can’t afford to spend money or just choose not to because they are concerned about various economic factors. The NBER is the group tasked with officially declaring that a recession is underway or complete and setting dates for each recession.

From an economist’s standpoint, one of the most important requirements for a downturn to be a recession is that gross domestic product (GDP) growth must be in the negative for at least two straight quarters. Other economists consider the market to be in a recession if unemployment rises by 1.5 to two percentage points within 12 months.

GDP growth and unemployment are only two of a host of factors that are affected by a recession. Other factors which are affected include consumption, investment, exports, government spending, household savings, government policies and more.

Why do recessions occur? 

Recessions can occur for a variety of different reasons, but many of them have to do with consumer or business confidence in the economy. Consumers spend less money on leisure and discretionary items when they’re worried about how the economy is doing and whether they might lose their job. Businesses may lay off workers if they’re worried that consumer demand will fall. Investors can also lose confidence in their investments, causing a stock market crash. 

Sometimes bad business decisions can cause a recession when they impact large swathes of the economy. For example, the 1990 recession was caused by the Savings and Loans Crisis, and more than 1,000 banks failed as a result of unethical and even illegal activities. 

Recessions can occur when the economy downshifts after a major event like a war. The popping of major asset bubbles can also trigger a recession. For example, when the housing bubble popped in 2006, home prices suddenly dropped, and the economy entered a deep recession amid the Subprime Mortgage Crisis.

Types of recessions

Economists use different shapes to refer to different types of recessions. These shapes are a sort of informal reference to describe each recession rather than an official classification system. The most common shapes are V-shaped, U-shaped, L-shaped and W-shaped. These shapes are described in these ways because of the shape formed by the data on economic charts during recessions. 

V-shaped recessions are formed when there’s a sudden but short decline in the economy. The trough is well-defined and followed by a strong recovery. Most recessions follow this shape because when the recovery rolls around, it can be as sudden as the decline which proceeded them. 

L-shaped recessions are prolonged and take the form of a somewhat slower decline followed by a lengthy period during which economic data simply moves sideways, forming an L. When an asset bubble bursts, a prolonged recession taking this shape often occurs.

U-shaped recessions last longer than V-shaped recessions, and the trough contains a number of up-and-down periods that aren’t as deep as the sudden decline or recovery. W-shaped recessions are also referred to as double-dip recessions. As the name suggests, there is a decline, followed by a sharp recovery that doesn’t last very long. The recovery is then followed by another deep decline before the real recovery finally arrives. 

Signs that a recession could be happening or on the way

Economists, investors and other market watchers look at several indicators to try to determine whether a recession is about to occur or perhaps is even underway. Among these indicators are weak outlooks, corporate earnings, an inverted yield curve and weak ISM manufacturing surveys.

Inverted yield curves are perhaps one of the most-watched recession indicators. The yield curve is formed by the yields on Treasury bonds of different maturities. However, a recession does not always occur after the yield curve inverts, so it isn’t a perfect indicator of a recession. 

Economic outlooks and corporate earnings may be added to other indicators such as the yield curve when trying to determine whether a recession is about to occur. Economic outlooks can be observed using various indicators like ISM manufacturing surveys and unemployment numbers. Economists and investors will also watch corporate earnings results for signs that revenue and earnings in multiple sectors are weakening. Companies will generally provide guidance for future earnings reports. When several of them offer weak guidance, it signals that a recession is widely expected by the corporate sector.

While these factors can suggest that a recession is just around the corner, none of them are reliable indicators on their own. The U.S. Conference Board’s Present Situation Index and Leading Economic Indicator are more concrete ways to tell whether a recession may be about to occur. The CFNAI Diffusion Index is also a reliable recession indicator. 

Recent recessions and what happened 

Although not everyone considers the economy to be in a recession at the same time, there have been many definite recessionary periods dating back to the founding of the country. The NBER defines the unofficial beginning and ending dates of recessions in the U.S.

In modern history, many recessions have been triggered by financial crises. For the 11 recessions which occurred between 1945 and 2011, the average duration was 10 months. On the other hand, the recessions which occurred between 1919 and 1945 lasted an average of 18 months. 

The Great Recession is freshest in the minds of investors, economists and market watchers. It occurred between December 2007 and June 2009, so it was longer than the average duration for that time period. Unemployment peaked at 10%, and the GDP declined 5.1% from peak to trough. The subprime mortgage crisis and the popping of the housing bubble led to the Great Recession. The plunge in home prices in the U.S. contributed to the global financial crisis, and inflation took off with soaring food and gas prices. Many major financial institutions in the U.S. collapsed or were bailed out during the Great Recession. The U.S. auto industry was also significantly impacted. 

Because the Great Recession remains fresh in the minds of investors and economists, much talk about the next recession focuses on whether it will be as severe as the Great Recession and how it might differ or resemble it.

How to invest during a recession

During a recession, many investments do not perform very well, so investors tend to rotate out of those that depend on a stronger economy, like certain sectors of the stock market, and into defensive or safe-haven assets like gold or bonds. However, value investors often run against the crowd, buying stocks while they’re cheap as they try to time the end of the recession.

In general, investors dial down the risk in their portfolios because they’re worried about what the immediate future holds for the markets. Government bonds and gold tend to be safer investments because the government will always be able to repay its debt, and gold can be a store of value when a recession hits. 

Stock investing during a recession usually focuses on defensive sectors and high-quality companies over cyclical sectors and riskier companies. High-quality companies are those with strong brands, steady balance sheets and predictable cash flows. Consumer staples tend to be a stronger sector to invest in because companies in the sector sell items consumers need, whether or not they are doing well financially. On the other hand, Consumer Discretionary companies sell items consumers will buy less of during a recession because they don’t need them and can’t afford them.

What does the Fed do about recessions?

In response to a recession, the Federal Reserve generally takes various steps aimed at increasing the money supply. These steps may include a number of expansionary monetary policies, increasing government spending or cutting taxes.

One of the first responses to a growing number of recession indicators is to lower interest rates. This makes it easier and cheaper for consumers and businesses to borrow money, thereby increasing the available money supply. By reducing interest rates, the Fed tries to stimulate the economy, hopefully helping support employment by enabling businesses to retain employees or hire more workers. 

The Federal Reserve also stimulates the economy by selling short-term government bonds and buying long-term bonds, thus further increasing the available money supply. When standard expansionary monetary supply stops working because interest rates are already at or near 0%, the Fed then takes extraordinary steps in quantitative easing. These steps may include purchasing slightly riskier credit like corporate bonds or mortgages. 

The rest of the articles in this series will go into each of these topics more in depth. 

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost