Preparing for a Recession
Q: If a recession is in the cards this year, what can people do to prepare themselves?
A: First, let’s level-set and define what we’re talking about.
The most popular definition of a recession, as articulated by economist Julius Shiskin in the 1970s, is two consecutive quarters of falling GDP (among some other rules). The National Bureau of Economic Research (NBER), the entity that sets official start and end dates of U.S. recessions, offers a bit of a broader view: “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.”
A typical recession lasts six to 12 months (the Great Recession, hardly typical, lasted 18 months between December 2007 and June 2009). The economy will generally lose 3 to 4 million jobs, and the stock market can obviously fall – sometimes significantly.
It should be noted that economies can slow down without entering into a recession. Bear markets, for example, happen when prices fall by 20% of more over the course of two months. That doesn’t necessarily mean the economy is in recession.
My first piece advice about recessions is not to be afraid of them.
In fact, I would even suggest that we should normalize the idea of recessions.
The Great Recession of 2008/2009 was bad, and it deeply affected a wide range of people. A few years ago, The Wall Street Journal even wrote about the enduring financial and psychological “scars” resulting from the “economic trauma.”
As a result, the Great Recession has understandably left everyone skittish about another recession, but it was an aberration by almost any metric. Moreover, it occurred in a very different set of circumstances from today (including some serious underlying problems in the banking industry that aren’t present today).
In fact, well-functioning economies experience both bear markets and recessions as a matter of course. It's healthy. A recession sort of sterilizes and absorb excess. We can get into environments where the economy has been overstimulated (especially after an overlong period of accommodative monetary and fiscal policy from the Federal Reserve). Because of that, we can end up with a misallocation of capital that leads to bubbles and strange events like NFTs. In other words, too much money can lead businesses and investors into making bad calls sometimes because the money feels cheap. When this happens, it is healthy and sensible for the economy as a whole to prune elements that have become overgrown before they start causing their own set of problems.
How can ordinary investors deal with a recession?
First, embrace it for the opportunities it offers.
I've always used periods like this as an opportunity to upgrade the portfolio, though not in a "I want to own low volatility or consumer staples or things that specifically hold up during recession" way.
Rather, if you have a wish list of companies you think will go from strong to stronger over the course of five to ten years, and they're now cheaper than they were before the recession, logic suggests that you get a little closer. There are a lot of world-class companies that are 30-50% cheaper during bear markets and recessions than they would be otherwise.
If you liked them six months before the downturn when they were hitting highs, all things being equal, they likely represent a better value today than they did back then.
For example, if you’ve been eyeing Amazon, their stock price was about $170 per share at the start of 2022. At the start of July, it was trading at $110. The
company hasn’t fundamentally changed in that time; the economic environment has, but only in ways that Amazon will likely navigate successfully. That means Amazon is being sold at a larger discount – it’s effectively “on sale” – relative to where it was six months prior.
If you still don’t like a company in a recession, that actually means you have made a new judgment about the long-term viability of the business and the competitive environment.
Most good companies will use recessions to get better and stronger, not just keep their heads above water. That might mean keeping prices low, not laying anyone off when competitors are, or showing incremental loyalty to employees and customers. It could be that the business itself takes advantage of reduced demand to acquire core adjacent businesses that maybe consolidate the industry a little bit. There are many strategic steps that are actually easier during an economic downturn that companies can take to expand their moat. In other words, well-positioned businesses can make hay out of a seemingly difficult situation.
If we get a recession, obviously near-term earnings will be lower across the board, but what hurts long-term is if there's an erosion of the business model. As long as any give company’s business model is strong, they remain a great buy whether we’re in a recession or not.
Second, don’t make fear-based decisions.
Beyond the financial decisions, there’s a psychological element to dealing with recessions. Most people are guided by short-term economic news and don’t really consider if their investments are well-suited for the long-term. Discipline and patience are pivotal to the value investing philosophy; they’re also in short supply among the general population of investors, especially amateur investors when seemingly scary things are happening in the market.
For those reasons, I try to disconnect myself from these issues regarding investing decisions. As I have discussed this before, I certainly pay attention to macroeconomic trends, but I am not a top-down macro investor. A value investor takes a more bottom-up investor who looks for strong businesses that are poised to generate value over a long period of time regardless of ever-changing economic conditions. This means the underlying business model and financial situation are stronger than average, so these organizations are typically positioned to weather recessions better than other companies.
As a result, downturns don’t interrupt my investing philosophy as much as they do for others. That helps make it easier for me to adopt a calmer and more patient attitude toward recessions.