How to Trade in a Recession: Should you be Investing or Trading?

Is it a good idea to invest or trade in a recession? Let’s look at the fundamental differences between the two before I go into more detail of what to look out for during a recession as an investor.

Investing in a share dealing account means adopting a long-term approach to the stock markets, riding out any losses, and capitalising on the stock market recovery over long periods.

Investing will likely lead to long term success, as past performance indicates markets will always eventually recover.

By contrast, trading involves short-term strategies which seek to maximise returns over much shorter time frames. Trading on volatility can return profits much faster, but at a steeper risk, especially for novices.

Also consider: Best Shares to Buy Now

5 ways to trade or invest during a recession

Is it good to invest during a recession?

As the risk of losing your job is increased, it is more important than ever to have enough freely available cash to cover three to six months of living expenses.

This helps ensure that you don’t cash out after you start investing for at least five years. On paper, it’s initially very possible to lose money invested, and the last thing you want to do is realise a loss to cover essential bills.

What happens to the stock market in a recession?

Stock markets fall in a recession, sometimes sharply. However, this can represent a rare opportunity to ‘buy the dip.’

Index fund investments are a popular choice, as they avoid the increased difficulties of stock-picking while simultaneously delivering a near-guarantee of future long term returns.

Of course, if you invest at the market low, you are going to make a financial killing. But timing the stock market accurately is extremely difficult, and interestingly, also completely unnecessary.

Rather, it’s time in the market that matters. If you had invested your money in a reputable S&P 500 tracker fund at the 2007 market peak, and held through the ensuing financial crisis bear market, you would have seen an 8.4% average yearly return through to 2020. [1]

Further, an investment bought at the 1990 high just before the falling markets would have seen a 9.8% yearly return.

This makes investing in index funds during a downturn very worthwhile, and there is no shame in sticking to this tried and tested wealth creation strategy.

Which stocks do well in a recession?

However, it’s perfectly possible to beat index returns through investing in individual stocks. Certain company sectors tend to do better in recessions, making them more attractive in the current climate.

These sectors include utilities, healthcare companies, and consumer staples companies; good FTSE 100 examples include Tesco, Unilever, British American Tobacco, AstraZeneca, National Grid and BT.

This is nowhere near an exhaustive list, but in general these ‘defensive stocks’ are preferred as safe havens for investor cash.

This preference is because most defensive stocks benefit from a concept known as inelasticity of demand. Regardless of external market volatility, their future results and share prices remain stable because they sell a service or product for which there is constant demand.

This might be because they hold an overwhelmingly dominant market position, have an excellent reputation, or in the case of the consumer staples sector, provide a basic necessity.

This usually also makes them reliable dividend stocks. [2]

As an example, inelasticity of demand explains the current gas and oil prices. Soaring post-pandemic demand combined with reduced Russian supply is seeing the cost of energy skyrocket, and remain unlikely to fall to prior levels any time soon.

Of course, even consumer staples are not completely recession-proof.

What should you not invest in during a recession?

Of course, over-investing into defensive stocks means you can miss the recovery in other sectors.

Financials, real estate, consumer discretionary, industrials, materials, and information technology companies all fare poorly in recessions, but conversely this means their discounted prices can make them high quality assets for future growth.

For balance, many investors advocate for a 70-30 portfolio percentage mix of defensive and growth stocks in recessions.

A word of caution at this point.

Stocks with a collapsing share price, high price-to-earnings ratios, high company debt, weak balance sheets, or low liquidity are high risk, as any recessionary financial problems become correspondingly magnified in the form of a lower stock price.

What happens to bonds in a recession?

Bond prices usually rise in a recession, which makes them another downturn portfolio safe haven. JP Morgan research shows global bonds rose by 12% during the 2008 crisis and 8% in the early 2000s dot-com crash. [3]

This is due to the long-term nature of the bond market, which tends to price in future investor sentiment. Ergo, by the time recession strikes, much of the harm to the bond market has already happened. It’s then already in the recovery phase, where investors place a high value on the certainty of fixed income.

In addition, central banks often buy bonds while lowering interest rates to stimulate weakening economies, especially when a recession appears stubborn.

Of course, this is a simplified overview. Many bonds have a complex relationship between their yields and interest rates. Older bonds, for example, with higher yields do better as rates fall, while younger bonds might have higher yields when rates rise.

Moreover, many central banks may choose to continue to increase rates despite difficult environments, preferring a sharp recession over untamed inflation.

As a rule, it’s a good idea for novices to steer clear of the bond market until they have built up significant confidence.

Investing in gold and gold stocks

Gold has long been seen as the standard portfolio real asset inflationary hedge, preserving purchasing power and acting as a protective asset in times of severe stress.

And yes, some critics — most famously Warren Buffett —argue gold produces no income and therefore has no intrinsic value. [4]

But in 2008, when the S&P 500 companies fell by 37%, gold rose by 24%. Now touching near record highs, many believe gold will rise further as recession takes grip.

Commonly, investors will choose to invest in a gold ETF such as the Invesco Physical Gold ETC rather than buy the metal direct, to benefit from the increased liquidity.

Others choose to invest in a gold mining company, which comes with its own risks and rewards. This strategy can deliver higher profit, but physical gold usually outperforms the miners in the long term.

Trading in stocks: CFDs

If you’re confident enough to trade stocks over short time frames, you should be familiar with using CFDs or spread betting to go long or short, taking advantage of being highly leveraged without having to take direct ownership.

Trading CFDs in a recession means you either:

1. Go short to profit from falling equities – Shorting enables you to take a speculative position on an asset, profiting if its price falls or suffering a loss if it rises.
2. Go long to profit from the recovery – Going long is usually riskier in a recession, as mistiming the market recovery can create substantial losses. Many investors wait for at least an initial recovery to take a position.

While CFDs offer many advantages, their biggest drawback is the high risk of realising unlimited losses.

While most investors place a stop loss to prevent this from happening, others use hedging to prevent too much loss in one direction.

Happily, using CFDs in a hedging strategy means losses can be offset against profits for tax purposes. [5]

Trading stock CFDs: popular strategies

Broadly speaking, stocks can be split into five categories for recession trading purposes.

1. Defensive stocks

As defensive stocks such as consumer staples usually rise in a recession, the usual strategy is to go long.

2. Cyclical stocks

Cyclicals usually see share price drops in recessions. As they are tied to the wider economic cycle, the strategy is to go short.

3. Speculative stocks

More complex, as speculative investments such as penny stocks or tech stocks can become volatile as investors either sell for safety or buy the dip. Go long or go short, but be ready to start losing money rapidly.

4. Strong balance sheets stocks

A company with significant cash reserves often fares poorly in good times, as it signifies that expansion is unlikely, especially if reserves increase over time.

However, companies with large cash piles are better able to cope with a downturn, allowing them to keep moving with limited income, and even picking up market share from weaker rivals. This can make them good choices for going long.

5. Takeover stocks

Companies with strong prospects but which are hit hard by a recession can become takeover targets for larger firms or private equity. Going long can be a good, though highly risky, strategy.

What happens to commodities in a recession?

Unsurprisingly, most commodities fall in price during economic downturns. Whether industrial metals like iron and nickel, agricultural products like wheat, or energy commodities like oil and gas, all come down as demand decreases.

This is especially true for perishables, or when storage costs become financially unviable.

An excellent example of how commodities fare in recessions is the oil surplus that occurred in the early days of the pandemic. With demand collapsing during global lockdowns, Brent Crude went negative for the first time ever. [6]

The general exception to the rule is precious metals such as gold or silver that are appraised as stores of value rather than for their practical uses.

Like stocks, some traders go short on commodities as recession hardens, while others invest by going long in anticipation of recovery.

Unlike stocks, commodities trading is best reserved for experienced traders, as the complex instruments can be rapidly affected by unforeseeable geopolitical developments, such as the Ukraine war, Shanghai lockdown, or even a global pandemic.

Forex trading

Sadly, Forex also isn’t recession-proof. But as different countries will start off in better or worse positions when the global recession hits, their initial positions will hugely influence their inflation and interest rates, which in turn are the primary factors affecting each currency’s value. [7]

Forex trading involves exploiting these currency fluctuations by trading a currency pair. This means going long on one currency while shorting another. Four major currency pairs, the EUR/USD, USD/JPY, GBP/USD, and USD/CHF, are by far the most popular choices.

If a central bank chooses to cut interest rates, the country’s currency becomes less appealing as a long term investment. These low-interest currencies are then usually sold to buy higher-interest currencies (a carry trade). [8]

Of course, we live in interesting times. Central banks may continue to increase rates, preferring to tame inflation at the expense of stoking recession.

What does a recession mean for my money?

In no particular order:

• Don’t panic and trust the process. On paper, after you invest it’s normal to lose money for some time until the economic recovery gets under way.
• Remember, history is firmly on your side. Don’t try to time the bottom exactly.
• Diversification becomes more important in a recessionary environment. If you have the expertise, spread investments across stock markets, bonds, gold, commodities and forex, and across multiple global markets.
• Pick the right retail investor accounts and fund trackers for you. They are not necessarily the cheapest.
• Drip-feed cash into your portfolio companies through pound-cost-averaging. Smaller amounts regularly invested over a long period of time will help smooth out volatility and could see you benefit from the entire recovery.
• Remember, low debt and cash balances matter now. Rising rates mean that a company’s cash pile is going to generate returns, while too much debt could start to affect growth negatively.
• Consider dividend stocks, including consumer staples. Even if payouts stop during a recession, increasing dividends will eventually resume.
• Perhaps outsource research. There are mutual funds managers who research market data providers and then create ready-made portfolios full of undervalued companies for you to invest in, with proven track records of success.
• Finally, avoid day trading companies unless you are an expert. It’s an easy way to lose money fast.

Trading and investing in a recession is a very different prospect to buying in a bull run. Good economic times, low interest rates, and easily available money make it fairly difficult for a competent investor to lose money.

By contrast, recession investing requires much more due diligence, often for weaker results.

However, as the Bank of England has predicted a severe recession that will last well into 2023, and CPI inflation is expected to exceed 13% by winter, [9] those with excess cash have little choice but to accept the additional risk.

What is a recession?

In the UK, a recession is defined as a period lasting two consecutive quarters or longer where the country’s gross domestic product (GDP) has contracted. [10] As it is hallmarked by a weakened economy, many instruments become unusually volatile, which can present unique opportunities.

What is a double-dip recession?

This is a rare but widely feared economic phenomenon which occurs when an economy experiences two recessions separated by a short-lived, somewhat artificial, recovery. Some prefer to call this a W-shaped recession, after the chart pattern.

The UK’s last double-dip recession occurred during the 1970s, though the country came very close to another during the worst days of the pandemic.

Conditions have to be exceptionally difficult for a double-dip recession to happen. For context, the US saw its last in 1982 during the OPEC oil crisis. After an initial economic downturn, surging inflation forced the Federal Reserve to increase interest rates to an unimaginable 21.6%, bringing on the second recession. [11]

But with conditions so adversarial, many investors remain nervous that a UK double-dip recession could be just around the corner for the economy.

What causes a recession?

Economic contractions are commonly seen as part of the natural ‘boom and bust’ cycle associated with stock market capitalism.

However, recessions are often sparked by:

• Unpredictable economic shocks to financial markets, such as the collapse of the sub-prime mortgage market in the States, or the covid-19 pandemic
• Falling income to debt ratios, where consumers suffering from falling income turn to debt to fund the essentials. The ripple effect can increase the risks of default and bankruptcy.
• Bank runs, where consumer panic leads to bankruptcies and liquidity issues. This was the fate of Northern Rock. [12] Fortunately, the FSCS £85,000 protection per banking licence makes a large-scale bank run unlikely in the UK.
• Collapsing asset bubbles, where inflated assets return to their fair value, usually in an uncontrolled manner. Often, this leads to stocks and bonds being oversold, alongside reduced spending by individuals and businesses.

When was the last recession?

Unsurprisingly, the UK’s most recent pandemic-induced recession was the worst on record, with GDP collapsing by more than 20% between April and June 2020. However, this was a special case as it was created by government-imposed lockdowns rather than underlying economic problems.

Many regard the 2008-2009 credit crunch as the last ‘true’ recession, as the UK’s GDP contracted for a full 15 months. [13]

FAQs about investing and trading in a recession

References

1. SPX | S&P 500 Index Advanced Charts | MarketWatch
2. Elasticity vs. Inelasticity of Demand: What’s the Difference? (investopedia.com)
3. Research (jpmorgan.com)
4. The Truth About Warren Buffett’s Investment In Gold (forbes.com)
5. How is Spread Betting and CFD Trading Taxed in the UK? | IG UK
6. US oil prices turn negative as demand dries up – BBC News
7. Interest Rates and the Forex Market (dailyfx.com)
8. What is Carry Trade in Forex & how it works? | AvaTrade
9. The Bank of England’s errors are mounting (telegraph.co.uk)
10. Recession Definition: What Is A Recession? – Forbes Advisor UK
11. Recession of 1981–82 | Federal Reserve History
12. The collapse of Northern Rock: Ten years on – BBC News
13. UK GDP falls faster than expected | Economic growth (GDP) | The Guardian

Please note:

This article has been prepared for information purposes only by Charles Archer. It does not constitute advice, and no party accepts any liability for either accuracy or for investing decisions made using the information provided.

Further, it is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

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