Recessions are considered part and parcel of a normal, functioning capitalistic society. Even with advances in predictive technology and forecasting capabilities, not many nations have managed to eliminate this scourge. Governments are armed with a plethora of “weapons” with which to tackle recessions and ensure they do minimal damage to economies. As investors, we need to be aware of how recessions affect share prices, and also how we can better position ourselves for the eventual recovery.
Amid an environment of pessimism, investors need to understand how to navigate stock markets and understand the effect recessions have on stock prices. By understanding how psychology affects valuations, investors are then able to make more informed choices regarding their investments. This would then empower them to have the courage, confidence, and conviction to act, rather than freezing like a rabbit in the headlights.
The recession “discount”
Recessions dampen overall demand for goods and services since they usually drag on the overall economy. Many people end up losing their jobs, suffering pay cuts, or having their bonuses eliminated. This causes businesses to hunker down and produce less, resulting in lower revenue and profitability.
Investors tend to price in a discount for businesses affected by a recession, as their growth prospects are usually dampened and profits are significantly lower. The pervading sense of pessimism causes low valuations, and companies start to trade much more cheaply compared to during the years of prosperity.
Because expectations for business recovery are low, shares are also priced cheaply with respect to their fundamentals. It is fairly common to survey the stock-market landscape and find an abundance of bargains during recessionary periods. Due to despondency and low expectations for many companies, investors are often faced with a buffet of choices and can take their time picking and choosing suitable companies to invest in. However, they should always be careful of potential value traps, as these may not recover when the economy turns up again.
Positioning for the eventual recovery
With share prices trading at a low, investors need to be discerning in selecting great companies in order to position their portfolios for the eventual recovery. This involves not just careful selection and navigating the minefield of bombed-out share prices, but also emotional control in reining in one’s fear and trepidation that things may get worse. As long as an investor has a long-term view and is purchasing great companies with a margin of safety, he should not be fearful of short-term price declines.
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