How to Prepare For a Recession
Reading time: 16 minutes
Did you know that two out of three people are simply not prepared for the next economic recession? It's an even scarier fact considering more and more economists are bracing for another recession in the near future. However, there are some simple ways to prepare for a recession such as understanding how the stock market can be affected and learning the recession-proof strategies used by global investors to potentially profit from it.
In this article, we explain what an economic recession is, what causes them, how they affect the economy and the stock market, as well as how to prepare for the next recession and several recession-proof strategies you can keep in your arsenal ready for the next economic recession.
What is an economic recession?
The National Bureau of Economic Research defines a recession as a "significant decline in economic activity spread across the economy, lasting more than a few months". The decline in economic activity is measured by the five following indicators: real gross domestic product (GDP), real income, employment, industrial production and retail sales.
Many economists and analysts take the definition one step further and define a recession as an economy having two negative quarters, consecutively, in GDP growth. There are other, more visible, indicators as well such as seeing businesses go bankrupt, lots of sales in the shops due to low consumer spending, a fall in house prices and high unemployment rates.
What causes an economic recession?
There are many causes of an economic recession. Some are triggered by wars and some by government policy actions. Generally speaking, an economic recession is caused by an imbalance in the economy which needs to be corrected.
For example, the cause of the 2008 economic recession was due to irrational exuberance in the housing market. Everyone thought house prices would keep going up, which led to many people buying houses they couldn't afford. The US Federal Reserve kept interest rates low, which encouraged more borrowing, further fuelled by interest-only loans.
Financial institutions created complex products mixing good loans with bad loans. When people started defaulting on their loans the market panicked, eventually leading to bank bankruptcies and a $700 billion government bailout plan.
While the 2008 recession was caused by excess debt in the economy, the 2001 recession was caused by inflated asset prices in technology stocks which led to the 'tech bubble' crash. In the past, each recession has been unique but there are some commonalities such as high-interest rates, asset price bubbles and extreme levels of inflation.
If you want to avoid being caught out in the next recession, an important step is making sure you have the right tools in your financial arsenal. One of these is MetaTrader 5 - the number 1 multi-asset trading platform in the world. A platform which Admiral Markets offers completely FREE! Access to superior charting capabilities, free real-time market data & analysis, the best trading widgets available, and more. Click on the banner below and download it completely FREE!
How does a recession affect the stock market?
It is important to note that the stock market is not an indicator of an economic recession. This is because the stock market represents investors' views on the future earnings of publicly listed companies, not the state of an economy.
However, in a recession consumers typically spend less, which can lead to job cuts, which can affect the profitability or the future earnings of a company. This is why there is typically an overlap between an economic recession and a stock market decline. For example, let's look at the 2008 financial recession and the Dow Jones 30 stock market index (DJI 30), which represents thirty American companies from a variety of sectors such as Apple, Nike, McDonald's and more.
Source: Admiral Markets MetaTrader 5, DJI 30 Monthly - Data range: from May 1, 2005, to Aug 15, 2019, accessed on Aug 15, 2019, at 1:56 pm BST. - Please note: Past performance is not a reliable indicator of future results.
The yellow box in the chart above shows the decline in the Dow Jones 30 index from October 2007 to March 2009. While the index declined significantly during this time, it bottomed out before the economy started to pick up again. This is because during a recession central banks will usually cut interest rates to make borrowing costs cheaper in the hope companies will use the capital to invest in growth, innovation, employment, and so on. The idea is to get the economy growing again.
Understanding this means you can start to prepare for the next recession by using recession-proof strategies, as the next sections describe.
How to prepare for a recession with Admiral Markets
Many people believe trying to pick the right time the economy goes into a recession is the most important way to prepare. In fact, having access to the right financial trading products to be able to capitalise on any major market moves is far more important.
Before we look at several recession-proof trading strategies here's how you can start to prepare for the next recession:
1. Open a trading account with a regulated broker
In times of economic uncertainty, such as a recession, you want confidence that your broker is serving your best interests and is running a competent operation. Brokers that are regulated by the world's most recognisable financial regulators such as the UK's Financial Conduct Authority (FCA) offer a higher degree of financial stability and security.
Admiral Markets is regulated by four of the world's most recognised financial regulators: the UK Financial Conduct Authority (FCA), the Australian Securities and Investments Commission (ASIC), the Cyprus Securities and Exchange Commission (CySEC) and the Estonian Financial Supervision Authority (EFSA).
2. Learn how to use Contracts for Difference (CFDs) to profit from a falling market
There are various benefits and risks of trading with CFDs. However, by trading with them users can potentially profit from falling markets as well as rising markets - this is something we discuss in more depth in our first recession-proof trading strategy below.
Learning the way CFD trading works could be useful in a recession where some markets are falling and some a rising, providing the flexibility needed to trade in a recession.
Users can also stick to a traditional share dealing account such as Invest.MT5 which allows the ability to invest in shares of a company. While you cannot profit from a falling market in this account there are other benefits such as the ability to collect dividend payouts. However, having the ability to access different financial trading products all from the same broker may prove to beneficial.
3. Practice trading on an easy to use, fast and secure trading platform
The world's most popular trading platform is MetaTrader (MetaTrader 4, MetaTrader 5, and MetaTrader WebTrader) which Admiral Markets users can download for FREE. Whether you are trading on a PC, Mac, Android or iOS system you can access the MetaTrader suite of trading platforms and enjoy superior charting features, a wide range of asset classes to trade on, free market data and news as well as a wide range of technical and fundamental trading indicators.
When preparing to trade the financial markets during a recession, it is important to already know how to use your trading platform, how to access different markets and how to place a live trade. This is because a lot of investors and traders will be scrambling to adjust and manage their portfolios appropriately, which can lead to markets moving very fast. You certainly don't want to be slowed down figuring out how to open up your trading platform!
A demo trading account is a perfect way to start practising in a risk-free environment, making sure you are ready when the time is right. Simply follow the steps in this video to get started:
Ready? Now you can open a FREE demo trading account with Admiral Markets by clicking on the banner below:
4. Familiarise yourself with multiple asset classes like Forex, Stocks, Commodities and Indices
There are a variety of markets to trade on in the financial markets such as Forex, Stocks, Commodities, Indices, Bonds and Cryptocurrencies. Some of these markets can show tendencies to rise or fall during a recession.
For example, in one of the recession-proof strategies in the next section, we will discuss the tendency for investors to move into 'safe-haven' assets such as Gold and the Swiss Franc.
A safe-haven asset refers to markets that are expected to retain their value even when global financial markets take a hit. The Swiss Franc is considered a safe-have due to the stability of the Swiss government and its financial system. Gold is considered a safe haven due to its use as a form of currency in ancient times.
Having an understanding of the different asset classes you can trade can help you prepare to trade in times of a recession, as you will discover in the next section.
How to prepare for the next recession
Once you have your live or demo trading account setup and the MetaTrader trading platform downloaded the next step in preparing for a recession is to build a trading plan with a basket of recession-proof trading strategies.
In this article, we will focus on three recession-proof strategies across a variety of markets. You can also view more strategies to use in different market conditions in the ' Trading Strategies for This Year' article.
Recession-proof trading strategies
To really understand the strategies below it is best to open up your Admiral Markets MetaTrader platform so you can follow the examples on your own charts.
# 1 Diversify your stock portfolio using sector rotation
For those holding shares of companies in a share-dealing portfolio, there is a risk that those shares could perform poorly during a recession. Some investors may try to 'hedge' their exposure by shorting index CFDs (explain in the next recession-proof strategy below). The aim is that any profits from trading a falling market will offset any losses from the declines in their share dealing portfolio. However, this is easier said than done.
In order to prepare for a recession, investors may consider using 'sector rotation'. This is the practice of rebalancing a stock portfolio into sectors that typically perform better. For example, in an economic recession, 'defensive' sectors such as consumer staples, utilities and health care tend to perform better than other sectors such as consumer discretionary, retail and so on. This is because these companies provide services or products that people will still need no matter what the economy is doing.
Investors may also try to flock to higher dividend yield stocks. If you invest in shares of a company, you are eligible to receive a dividend which is essentially a piece of the profits. Essentially, investors try to find the best dividend stocks for income.
One of the simplest ways to start investing in shares is by opening an Invest.MT5 account, which enables you to invest in stocks and ETFs from 15 of the world's largest stock exchanges through the MetaTrader 5 trading platform. Other benefits include free real-time market data, premium market updates, zero account maintenance fees, low transaction commissions and dividend payouts! You can open an investing account by clicking the banner below:
# 2 Short Stock Index CFDs
With Admiral Markets you can trade on a range of index CFDs such as the Dow Jones 30 (DJI 30), the German DAX 30 (DAX 30) and the FTSE 100 among others. To see which markets you can trade on, follow these steps:
- Open MetaTrader.
- Open the Market Watch section from the View menu at the top or by pressing Ctrl+M on your keyboard. This will open up a list of market symbols on the left side of your chart.
- Right-click on the Market Watch window and select Symbols or press Ctrl+U on your keyboard.
- This will then open the window shown below which details all the markets available for you to trade on.
- Select Cash Indices.
Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.
Stock market indices represent a selection of different publicly listed companies. For example, the Dow Jones 30 index is calculated using the closing prices and market capitalisation of 30 American companies. These include Apple, Boeing, Pfizer, Microsoft, Nike, Wal-Mart and more.
As companies tend to struggle in times of an economic recession there share prices tend to fall. So, rather than buying a share or investing in an index with the expectation that the price will go up and you will sell at a profit, you can do the reverse by trading stock index CFDs.
As the individual share prices fall, so does the index that holds them. Therefore, traders often sell or 'short' indices to potentially profit from falling prices. Using CFDs allows you to open a 'Sell' trade, which means you sell the CFD at a higher price with the hope that the price will fall and you can close the trade by buying it back at a lower price, and making a profit on the difference.
Of course, if the market rises the trader will be losing money so risk management is essential.
For beginner traders, it's better to keep the risk low at first and use stop-losses which are price order levels you place in your trading order ticket to get out of the market at a fixed price to minimise any losses. To short an index CFD, follow these steps:
- Use a trading strategy to identify possible entry, stop loss and target price levels.
- Select the index in the MetaTrader platform by selecting the index in the Market Watch window, left-click on it, hold and drag on to the chart and release.
- Right-click on the chart, select Trading -> New Order, or press F9 on your keyboard.
- The order ticket shown below will pop up and traders can click sell or buy.
Now the question is, what trading strategy or tools do you use to help identify when to short the market? There are a variety of tools that traders can use to their advantage such as technical indicators and price action trading patterns. Examples of these can be seen in the 'Trading Strategies for This Year' article.
# 3 Buy Gold CFDs
Gold is a popular market for traders and investors in times of economic uncertainty. This is because of its status as a 'safe-haven' asset, as the history of gold dates back to ancient times when it was used as a form of currency. In the 2008 financial recession, investors exited the stock market in favour of the gold market, as the chart below shows:
Source: Admiral Markets MetaTrader 5, Gold, Monthly - Data range: from Jan 1, 1992, to Aug 15, 2019, accessed on Aug 15, 2019, at 4:08 pm BST. - Please note: Past performance is not a reliable indicator of future results.
In the long-term chart above of gold, the yellow box highlights the beginning of 2008 to the peak the gold market reached in September 2011. While gold prices were already moving higher before the financial recession the move accelerated to the upside when the aftermath of the recession hit in company bankruptcies and bank bailouts.
Of all the precious metals, gold is the biggest market and one which offers investors diversification in times of an economic recession as well as short-term and long-term trading opportunities due to its high price volatility and directional trend bias. Traders with Admiral Markets can trade on gold, commission-free.
How to prepare for the next recession today
Having access to flexible trading products, a variety of asset classes and a fast, secure trading platform are essential in preparing for the next recession. With Admiral Markets you can:
- Trade with a well-established broker regulated by four global financial regulators including the UK's Financial Conduct Authority.
- Access the fastest and most secure trading platforms from MetaTrader on PC, Mac, Android and iOS.
- Trade 24 hours a day, five days a week.
- Benefit from a negative balance protection policy for peace of mind.
If you're feeling inspired to start trading, or this article has provided some extra insight to your existing trading knowledge, you may be pleased to know that Admiral Markets provides the ability to trade with Forex and CFDs on up to 80+ currencies, with the latest market updates and technical analysis provided for FREE! Click the banner below to open your live account today!
About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.