Recession: The last stage of a business cycle

Sir Isaac Newton once said, “What goes up must come down” when describing the properties of gravity, and the same applies to a business cycle -- which is the continued rise and fall of the economy over the course of many years. An economic recession is the last stage of the business cycle when the economy shrinks in size, usually over a period of six months or more. The good news is, after a recession, economic growth often follows.

Recessions can create opportunities for growth

While recessions can potentially lead to some job losses and companies going bankrupt, at the same time, prices of goods and services usually fall, as do interest rates. Although recessions may create personal hardship for some, they also create opportunities once the economy begins to recover. This is because, as the needs and spending habits of consumers adapt to governmental and financial changes, it can create opportunities for investors to take advantage of.

What causes a recession?

Recessions can occur for a variety of reasons. Recent recessions were caused by the bursting of the tech and housing bubbles, in 2000 and 2008 respectively. Earlier recessions have been attributed to monetary policy decisions by the Federal Reserve, global growth shocks from political changes or events, and other economic factors.

A recovery typically follows a recession

This chart shows the trend in economic growth over the past 50 years, with the bars representing quarterly economic growth rates. The left axis represents the percentage growth in Gross Domestic Product (GDP) -- which is the total value of goods and services produced in a country -- and the bottom axis represents the year. It’s easy to see periods of recessions when there is negative growth (bars below the 0% line), followed by economic recoveries with strong positive growth (bars above the 0% line).

Chart: U.S. economic growth measured as year-over-year Gross Domestic Product (GDP) growth on a quarterly basis
Source: Clearnomics, U.S. Bureau of Economic Analysis

Volatility doesn’t always signal a recession

It’s true that the stock market tends to crash during recessions. This may seem obvious, and it's because economic growth and corporate profits are major drivers of stock market returns. When economic growth turns negative, so too do stock returns. In fact, even though the tech bubble of 2000 was a rather shallow economic recession, it was a severe bear market for stocks.

However, the opposite is NOT always true - i.e., the stock market can decrease without a similar decline in economic growth. We repeat: A stock market drop does not mean a recession is coming. This is because the stock market experiences large swings on a regular basis. That’s why you shouldn't necessarily overreact and fear the worst when the stock market becomes volatile.

Diversification helps protect your portfolio during a recession

During recessionary periods, other asset classes may do better than the stock market. For instance, safer bonds and other types of fixed income may do very well as investors seek safety and ways to protect their wealth. This is an important reason to hold a diversified portfolio that contains all of these asset classes rather than being concentrated in a particular sector or asset class, especially if there is economic uncertainty on the horizon.

The economy is like a beating heart

Eventually, after a recession, the economy begins to recover. When this occurs, the stock market can rebound quickly as conditions improve. You can think of the economy as a beating heart; in order to grow stronger and increase blood flow, we need times of both expansion and contraction (ba bump, ba bump). A recession is a time of economic contraction that is often followed by a time of expansion -- or economic growth. The ability for investors to stay invested, or better yet, take advantage of low prices, is often rewarded as the business cycle begins anew. So take a deep breath and let the economy continue to beat!