Lesson 29 of 43: How to Profit During Economic Recessions

  • Our research shows that deep market sell-offs can act almost like an overstretched rubber band that snaps back into place, driving a fast and strong recovery.
  • Recession forecasting involves using robust economic data and forecast modeling to spot upcoming recessions and adjust our investment strategy accordingly.
  • Once you spot a recession coming, you may want to “play defense,” which involves sidestepping the upcoming decline by moving your money into something low-risk.
  • Alternatively, you may want to “play offense,” which involves embracing the upcoming decline by moving your money into something that profits when the market declines.

Trying to time the market and avoid declines is a classic mistake that costs many investors dearly.

Sure, it seems like a good concept. If it looks like stocks are overvalued or there’s an upcoming economic threat on the horizon, why not jump out now and avoid the crash?

The thinking goes like this:

“Maybe not today, maybe not tomorrow, but sometime soon the stock market just has to crash and I don’t want to be invested in stocks when it does.”

The problem is research suggests it’s very difficult for investors to correctly time the market.

And when they try, it often comes at a high cost: missing out on big gains.

Interestingly, the majority of the stock market’s gains happen during very short periods of time. Market profits aren’t evenly distributed throughout time.

In fact, the Cogent Advisor shows that since 1927, just 8.5% of the months have provided nearly 100% of the stock market’s returns.

And from their report titled, “10 Ways to Beat an Index“, investment firm Tweedy, Browne said: 

“Stay as Fully Invested as Possible: Empirical research has shown that 80%–90% of investment returns have occurred in spurts that amount to 2%–7% of the total length of time of the holding period. The rest of the time, stocks’ returns have been small. With stocks, you have to be in to win.”

If you were to miss some of the best months (or even the best days) while trying to time the market, your returns could take a massive hit.

Just look at this chart from Calamos Investments which shows the enormous cost of missing just a few of the best days from the past 20 years.

We discussed market crashes extensively in Lesson 10: Stock Market Crashes: Why Markets Decline & How to Survive.

Let’s look at a brief recap of the major takeaways here:

  • There are three different levels of stock market decline: Pullbacks (5% – 9% decline), corrections (10% – 19% decline), and bear markets (20%+ decline).
  • Not every market decline is a “stock market crash,” which is marked by a large sudden decline across several market indexes and widespread investor panic.
  • Stock market declines have many causes and they tend to manifest in uniquely different ways each time.
  • Healthy markets regularly experience pullbacks and corrections. Even bear markets are a normal part of long-term economic growth.
  • After stock market declines, recoveries can provide huge gains over the following one, five, and ten-year periods.
  • Don’t try to time the market. It’s very difficult to do well and missing out on just a few days of strong market performance can seriously hurt your long-term returns.
  • To survive a stock market selloff, don’t panic, tune out the noise, stay diversified, carefully analyze your situation, and look for high-quality stocks to buy at discount prices.
  • Buying high-quality stocks throughout a market decline can provide tremendous profits over the following years.

In addition we wrote an Investor Q&A titled, “Should I Sell Everything Now to Avoid a Stock Market Crash?” where we cautioned against trying to time the market.

One of the major takeaways was that it’s not clear that anyone (even the experts) can successfully know when, exactly, is the right time to sell.

Granted, there are always exceptions. If you’re a day trader or swing trader who has made a living at moving in and out of positions by reading market technicals, you may be able to profit by timing the market.

We wouldn’t want to discourage anyone from trying to profit from market timing by saying, “It’s impossible.”

In fact, it’s probably very possible to do well. 

But for your average (or even advanced) stock market investor, who has a limited amount of time, energy, and research tools to execute such a complex investing strategy, correctly timing the stock market is likely to be very difficult. 

In fact, history suggests the average investor makes market timing decisions based on emotions and headlines, rather than thorough technical analysis. It’s these emotion-driven decisions that can drive us to buy high (“Everything keeps going up, I’ve got to get in!”) and sell low (“The market keeps crashing, I need to get out now!”).

So, in general, we would suggest that the average investor NOT try to time the market. It’s likely to do more harm than good.

However, there’s one important exception which could help save investors a lot of money and perhaps even profit from a downturn.

Market Timing vs. Recession Forecasting

There are two main reasons why investors get burned by trying to time the market:

  • They’re afraid to lose money, so they’re quick to sell when the market dips and fast to buy when the market surges.
  • They’re not good at it. When investors become afraid, they watch the market’s every twitch and end up jumping in and out at the exact wrong times.

Investors who are making many buy and sell decisions based on the market’s every move are destined to underperform.

But we’ve developed another approach which focuses on the “signal” and ignores the “noise.”

Our first principle is that markets are going to rise and fall over time and it’s not worth trying to time those little moves.

As we discussed at length above, market timing may be a profitable game for short-term technical traders, but it’s a deadly game for the average investor.

Remember, it’s very normal for markets to decline by -5%, -10%, -15%, even -20%.

Looking at this chart from American Century Investments, we can see there have actually been many bear markets and corrections throughout history. 

In fact, the end of 2018 provides an excellent example.

From late September through late December of 2018 (roughly three months), the S&P 500 and Nasdaq declined -19.3% and -21.5%, respectively.

Then, just as quickly as they declined, they staged a rapid comeback.

From late December, 2018 through early February, 2019 (roughly one month), the S&P 500 and Nasdaq gained +16.5% and +19.2%, respectively. 

Living through such market whipsaws is painful. When it’s happening, it feels like you’re strapped into a roller coaster.

But this type of volatility is an inevitable part of investing in stocks and an advanced investor must learn to accept it.

Put another way, it’s difficult for an investor to earn healthy long-term profits if he flinches every time the market dips.

So, rather than trying to dodge every little bump in the road, our goal is to spot the giant brick wall coming up just over the horizon.

Put simply, we accept occasional market volatility but we try to spot and prepare for the enormous drawdowns that come from economic recessions.

Our research suggests it’s too hard and too unprofitable to try and dodge every little bump in the market. It’s actually easier (and highly profitable) to avoid “The Big One.”

For example, the recession of 2007 – 2009 saw the S&P 500 decline by a stunning -55%.

And during the dot-com recession of 2000 – 2002, the S&P plummeted by -48%.

Can you imagine (or remember) seeing your money get cut in half?

Now THAT’S a decline worth trying to avoid.

Let’s look at this chart from Yardeni Research which shows the S&P 500 during recessions:

You can see how much the S&P 500 declined during the shaded areas (recession periods). Declines of that magnitude are worth trying to anticipate.

Plus the sell-offs are often so large that you can afford to be a bit slow to realize what’s happening and still benefit from dodging some of the massive decline. 

But hold on, isn’t this the same as market timing, which we discouraged earlier?

We don’t think so.

When most investors are market timing, they’re trying to perfectly time small gains and declines in the market, usually based on nothing more than emotion and market movement. This approach is destined to fail.

What we practice is recession forecasting, which involves using robust economic data and forecast modeling to spot upcoming recessions and adjust our investment strategy accordingly.

Can you spot the three big differences there? Here they are:

  1. Market timing tries to avoid every market decline whereas recession forecasting tries to avoid the one BIG decline that comes with an economic recession.
  2. Market timing is often based on market movements and investor emotion whereas recession forecasting is based on extensive analysis of economic data and forecast modeling.
  3. Market timing involves jumping in and out of stocks whereas recession forecasting involves carefully adjusting our investment strategy.

When investors try to time the market by watching the market, they’re not basing their decisions on any meaningful data. Instead, they’re just following the herd.

By analyzing economic data, we aim to see the cracks in the economy before the market catches on and sells off.

So, to summarize, we believe in recession forecasting (but not market timing), which is based on three major principles:

  1. Avoid the one BIG market decline that comes with economic recession to dramatically improve long-term returns.
  2. Watch for recessions by analyzing economic data and modeling economic forecasts.
  3. Adjust investment strategies for upcoming recessions based on investment goals.

We’ve talked about #1 (why it’s worth avoiding the big declines that come with recessions) above.

In terms of #2 (economic forecast modeling), that’s a deep and complex topic best suited for a future lesson (which we haven’t yet written).

For now, we’ll simply say that there are a wide range of economic indicators that have historically shown an ability to forecast recessions. We use them to guide the investment decisions in our paid recommendation newsletters.

And now, let’s talk about #3, how to adjust your investment strategy when you spot a recession coming.

Depending on your investment goals and risk / reward profile, you can either play defense, or offense, or a mix of both.

Playing Defense During a Recession

Once you spot a recession coming, you may want to “play defense,” which involves sidestepping the upcoming decline by moving your money into something low-risk.

There are several different types of assets that will allow you to play defense. Each has their own advantages and disadvantages.

You could move everything (or a portion of your portfolio) to:

  • Cash
  • Bonds / bond fund
  • Money market fund
  • Certificates of Deposit (CDs)
  • Defensive dividend stocks
  • Market neutral fund

In addition to the above (or instead), you can pursue stock investment strategies that have proven to perform best during recessionary periods.

Based on our extensive research, we find that high-quality, low-volatility stocks with steady growth tend to perform best during recessions. High dividend stocks also perform well.

Value investing, on the other hand, has struggled during past recessions as nearly all stocks are sold off, reducing valuations across the board.

There are many defensive choices available and which is the best fit depends on the economic situation and your personal goals.

And while some investors choose to simply play defense during a recession, others prefer to go on the offensive.

Playing Defense During a Recession

Once you spot a recession coming, you may want to “play offense,” which involves embracing the upcoming decline by moving your money into something that profits when the market declines.

There are several different types of assets that will allow you to play offense. Each has their own advantages and disadvantages.

You could move everything (or a portion of your portfolio) to:

  • Inverse ETFs
  • Leveraged ETFs
  • Volatility ETFs
  • Short individual stocks

Inverse ETFs are Exchange-Traded Funds that perform inversely to their benchmarks.

For example, the ProShares Short S&P 500 ETF (SH) will gain 1% when the the S&P 500 (SPY) declines by 1%. And it will lose 1% when the S&P 500 gains 1%.

If you think a recession is coming, you can buy inverse ETFs that will profit as markets decline.

Some investors take their offense a step further and buy leveraged inverse ETFs, which deliver inverse returns of 2x or 3x or more than their benchmark.

So, if the S&P 500 (SPY) declines by 1%, the Direxion Daily S&P 500 Bear 3X ETF (SPXS) will increase by 3%.

Leveraged ETFs are high risk, and we would NOT recommend using them unless you’ve really done your homework.

Similarly, a volatility fund such as the ProShares VIX Short-Term Futures (VIXY) tracks market volatility, increasing in price when volatility increases and declining in price when volatility declines.

Finally, you could pick individual stocks to short, which means you profit when their price declines. However, this is another high-risk strategy we wouldn’t recommend. 

For most investors looking to play offense during a recession, a simple inverse ETF is probably the best choice.

But keep in mind your returns with such a strategy are limited. During a recession the market may decline by -20%, -30%, -40%, or even -50%. But declines beyond that range are very unusual.

And if the market and economy stage a strong recovery, your inverse bet may get burned, which brings us to another very important point:

One of the most powerful strategies for profiting during a recession is buying high-quality, growing companies during the recovery.

Recession Recoveries Can Offer Incredible Profits

Our research shows that deep market sell-offs can act almost like an overstretched rubber band that snaps back into place, driving a fast and strong recovery.

When the market sells off hard, it has a tendency to rally just as hard afterward.

For example, look at this chart from Fidelity which shows the incredible triple-digit returns in the market after several painful bear markets.

Similarly, this table from American Century Investments shows the 1-year, 5-year, and 10-year recoveries after several market downturns.

One thing to note, this table doesn’t include dividends. If dividends were included the declines they report would be smaller and the returns would be bigger.

There are a few important takeaways from this table:

  • The average downturn lasted 21 months (just under two years).
  • The average downturn decline was roughly 40% from market peak to trough.
  • The average return one year into the recovery was 47%.
  • The average return five years into the recovery was 109%.
  • The average return 10 years into the recovery was 195%.

This underscores two very important points:

  1. When markets decline hard, they’re often set up to recover and deliver a large return in the following years.
  2. If you had bought more shares towards the bottom of historical downturns (or more likely, bought steadily throughout the downturn), you would’ve realized tremendous returns over the following years.

Let’s look at a few examples of high-quality, growing stocks during the recovery from the 2007 – 2009 recession.

We’ll start by showing Apple’s (AAPL) decline during the recession, followed by it’s incredible recovery rally

Apple during the recession:

And Apple during the subsequent recovery:

And here are several other examples of incredible rallies after the recession:

The bottom line is even though recessions can do lots of damage to your portfolio, they also provide amazing opportunities to book fast profits.

Which leads us to one of the toughest questions of all: When do we jump back in?

How Do You Know When to Get Back In?

If you can manage to avoid some of the large declines that often come along with an economic recession, you’ve accomplished something incredible.

Now, the next very important task is getting back into stocks to ride the fast recovery.

But how do you know when the time is right?

To be honest, it isn’t an exact science. It’s especially hard because the market starts to recover long before the recession officially ends.

So, knowing when to shift strategies requires a mix of art of science to get right, and there are a few clues that can help point us in the right direction.

First, it’s important to keep this simple rule in mind:

Deciding when to get back into stocks during a recession is an exercise in balancing risk vs. reward. At any point in time, ask yourself, “How much reward is really left by continuing to bet against this market?”

Recessions don’t last forever and markets don’t decline forever. At some point there’s not much reward left in betting against the market, and you’re probably better off shifting your strategy.

In fact, we have good historical data on typical recession duration and market loss amount from Advisor Perspectives.

(You may notice that some of the recession duration figures below differ from the American Century Investments chart above. That’s because the table below is using the official recession dates from the National Bureau of Economic Research, whereas the table above is using broader dates.)

Let’s look first at the “Number of Months” column.

We can see that most recessions typically last between 8-16 months. Yes, there are exceptions. But the Great Depression of 1929 is the only recession that falls far outside that range.

So, when deciding the risk / reward tradeoff we can look at when the recession started and see how long it has lasted.

In addition, we know how much markets tend to decline during recessions.

Looking at the “Market Price, Peak to Trough” column we can see declines typically range from -20% to -50%. Yes, there are exceptions. But most tend to fall within that range.

So, when deciding the risk / reward tradeoff we can look at how far the market has declined from its peak.

For example, if we’re 15 months into a recession and the market has declined by -45%, there probably isn’t much downside left.

Now, there will always be situations that “break the rule” and fall far outside the normal range. But overall, in a situation like the above, nine times out of ten you’re probably better off putting your money in high-quality growth stocks (betting on a recovery) than in a triple leveraged inverse ETF (betting on more declines).

The point is this: As recession duration and declines continue to accumulate, you should be shifting towards an increasingly bullish stance.

Plus, keep in mind that you don’t need to pick the exact top (peak) and bottom (trough) of the market. That’s nearly impossible to do correctly, so don’t even try. 

Instead, carefully shift from recession defense (or offense) back into stocks as the risk / reward tradeoff becomes more attractive. 

For example, if the market has declined -30% and we’re 10 months into the recession, it could be a good time to buy a few high-quality stocks for cheap.

Sure, the market could decline another -20%+ from here, but you’ve still got a great company at a cheap price, which means big profits when the recovery comes. 

Finally, just like when we scan the horizon for upcoming recessions, we constantly analyze economic data and rely on forecasting tools to spot when the economy has stabilized and is set to begin a recovery.

While it will never be exact, avoiding (or better yet, profiting from) even a portion of a nasty economic recession can make an enormous difference in your long-term profits.

Lesson Summary: How to Profit During Economic Recessions

In this lesson we covered a range topics on why recessions are damaging and how to avoid (and profit) from them.

Here’s a quick summary of the major takeaways from today’s lesson:

  • Don’t try to time the market. It’s very difficult to do well and missing out on just a few days of strong market performance can seriously hurt your long-term returns.
  • Investors get burned when trying to time the market because they’re overly risk-averse and rely on emotion-driven decision making rather than data and analysis.
  • Healthy markets regularly experience pullbacks and corrections. Even bear markets are a normal part of long-term economic growth.
  • After stock market declines, recoveries can provide huge gains over the following one, five, and ten-year periods.
  • Our research shows that deep market sell-offs can act almost like an overstretched rubber band that snaps back into place, driving a fast and strong recovery.
  • We accept normal market volatility, but we try to spot and prepare for the enormous drawdowns that come from economic recessions.
  • Recession forecasting involves using robust economic data and forecast modeling to spot upcoming recessions and adjust our investment strategy accordingly.
  • Once you spot a recession coming, you may want to “play defense,” which involves sidestepping the upcoming decline by moving your money into something low-risk.
  • Alternatively, you may want to “play offense,” which involves embracing the upcoming decline by moving your money into something that profits when the market declines.
  • One of the most powerful strategies for profiting during a recession is to buy high-quality, growing companies during the recovery.
  • Knowing when to shift strategies requires a mix of art and science to get right. Watch economic data and forecasts closely while keeping an eye on recession duration and the size of market drawdowns.
  • While it will never be exact, avoiding (or better yet, profiting from) even a portion of a nasty economic recession can make an enormous difference in your long-term profits.
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Author

Todd Lincoln

Author

Passionate stock market investor with deep experience trading small cap, dividend, and growth stocks.

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