Recession
A recession is a broad, sustained decline in economic activity: output, employment, income, and spending falling together. Two consecutive quarters of shrinking GDP is the popular shorthand; in the United States, the National Bureau of Economic Research dates recessions using a wider set of indicators, and typically does so well after the downturn has begun.
The math
Recessions hit stocks twice, and the two hits compound. Take a cyclical company earning $10 per share and trading at 20 times earnings: $200.
A downturn cuts earnings 30 percent to $7, and nervous investors compress the multiple to 15. The new price is 15 x 7 = $105, a 47.5 percent drop produced by a 30 percent earnings decline.
| Before | In the downturn | |
|---|---|---|
| Earnings per share | $10 | $7 |
| P/E multiple | 20x | 15x |
| Share price | $200 | $105 |
| $10,000 position | $10,000 | $5,250 |
A $10,000 position becomes $5,250. The same double effect runs in reverse during recoveries, when earnings and multiples expand together, which is why rebounds can be as violent as the falls that preceded them.
The trap
Selling on the headline. Because official recession declarations lag the economy by design, the announcement often lands after markets have spent months pricing in the damage.
The investor who exits on the news frequently sells near the point of maximum pessimism, then waits for an official all clear that arrives, just as late, after prices have already recovered. Acting on dated labels means transacting against people acting on current prices.
The move
Prepare rather than predict. A long-term stock picker audits holdings for recession survivability before one arrives: interest coverage that handles two bad years, no refinancing wall at the wrong moment, demand that bends without breaking.
Done early, that audit converts a downturn from a threat into a shopping window, because the compressed multiples of durable businesses are where patient capital gets its best prices.
Reference: NBER business cycle dating