What is a Recession?

By Mike Mc Mahon | Updated: January 30, 2020

A marked decline in a region’s economy that lasts for a significant period of time is referred to as a recession. Classically defined, recessions occur when a country’s Gross Domestic Product (GDP) drops for 2 or more quarters.

Founded in 1920, The National Bureau of Economic Research (NBER) is a “private, non-profit, non-partisan organization dedicated to conducting economic research and to disseminating research findings among academics, public policy makers, and business professionals”. It is relied upon for official confirmation that a recession has taken place.

While a recession could be confirmed more quickly by independently compiling the data, neither independently compiling data nor the NBER are timely in respect to allowing traders and investors the opportunity to protect their investments.

Plummeting arrows on a stock chart indicating a recession

What Causes a Recession?

Recessions are the natural swing of momentum to the downside after a move up; but though all recessions may have similarities, there are specific, unique causes as well. The fact is, economists cannot agree on exactly what causes a recession to occur. Most do agree that recessions are a necessary part of the business cycle. Corrections to expanding valuations need to occasionally occur to help keep supply and demand close to a normal balance.

While recessions are necessary to all economies and typically last only a few months to a few years, some are very painful. In 1893, the failure of the Reading Railroad was the key component of a recession that lasted approximately four years. Unemployment topped 10% and over 400 banks closed their doors during that time.

Other recessions have been caused intentionally by the Federal Open Market Committee (FOMC or The Fed) that controls the monetary policies of the U.S. government with respect to the economy. While not directly tied to the marketplace, the elevation or reduction of interest rates causes the cost of doing business to oscillate. The 1980-82 contraction was set in motion to control an inflationary hot spot. The Fed utilized interest rate increases until the economy slowed into a mild recession. This is often called a soft landing – the nice kind of recession.

Some recessions have been the result of a mistake, a miscalculation of how much slowing will be caused by too much, or too rapid, an increase in interest rates. This occurred in 1957 when The Fed's contractionary monetary policy led to a 9-month economic slowdown.

Warning Signs of an Impending Recession

Downturns in the economy are generally associated with changes in short term interest rates. These changes manifest themselves as anomalies in the yield curve of Treasury issued bills, notes and bonds with differing maturity dates. Simply put, a longer-term bond should support a higher yield of interest than one with a shorter term. However, if the Fed raises the short term interest rates too quickly or too far, it can result in an equal or higher return on shorter term than their longer term counterparts. This is referred to as an inverted yield curve. While not all inverted yield curves have produced a significant recession, all recessions have been preceded by a rate inversion.

Other signs that “people in the know” watch for are consumer confidence polls that are part of economic reporting. Some of these reports are produced by the private sector, such as the University of Michigan, while others are put out by the government itself. Examples are employment data that is released once a month, the Federal Reserve Bank of New York's recession probability model, and another set of data called the Leading Economic Index which is an amalgam of 7 reports related to GDP, such as unemployment insurance claims, housing permits, housing starts and securities valuations. All of this data can offer insights about the strength of the economy.

Depression vs. Recessions

Depressions are recessions that have gone too far. A Depression is said to occur when a country’s GDP falls 10% or more and stays that way for 3 or more years. The best example is the Great Depression of the 1930s which lasted 10 years and held the U.S. in the grasp of utter poverty. Unemployment climbed to nearly 25 percent in 1933 and remained in the double-digits until 1941.

A recession is a normal part of the business cycle that generally occurs when GDP contracts for at least two quarters. On the other hand, depressions are an extreme collapse in economic activity that lasts for years, rather than just several quarters. This makes recessions much more common: since 1900, there have been 21 recessions and just one depression.

Recessions manifest themselves in our economy in several ways. Industrial production is curtailed, unemployment rises, values of stock and other security markets drop, and disposable income along with wholesale-retail trade declines.

How to Prepare for a Recession

  1. Build an emergency fund to cover costs of living for at least 6 months . This would include mortgage/rent, utilities, medications, food, and an additional 10% in cash. This allows you to do some bottom fishing for investments as the recession wanes.
  2. Diversify investments. Most stock sectors will feel the drop; however, an excellent diversification plan would include other asset classes such precious metals and interest bearing instruments. These are recessionary fighters. So, while stocks may drop, other commodities will probably increase in value. This offers a resource beyond the emergency nest egg.
  3. Get a side job or at least have a plan in the event of being laid off or terminated by a failing company. Any job that keeps the cash flowing is a good thing, being over-qualified is irrelevant. Once the economy improves, having the benefit of a consistent work history could assist in reclaiming previous positions.
  4. If possible, lower fixed living costs. For most, this can be done by setting a more stringent budget and getting along without dining out, etc. If feasible, walk to the store to pick things up. Leaving the car home has the added benefit of improving one’s health. A quick inventory of one week’s expenditures might be shocking and prompt a few questions, like: Did I really need this or that? Was that a good buy? How much could be saved with coupons or discounts?

Though recessions can be a scary part of the business cycle, understanding and preparing for them is relatively easy for the educated investor. Start making a list of things to do to help you and yours through some of the hard times.

About the Author
Mike Mc Mahon

Mike Mc Mahon was a co-founder of Online Trading Academy in 1997 and was Director of Education for 13 years. He is well versed in economics and has addressed the London School of Economics and participated in the Salon de L'Analyse in France. Though officially retired, Mike fulfills his passion for sharing knowledge by remaining a member of Online Trading Academy's content team.

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