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[h=1]Recession: What Does It Mean To Investors?[/h]
March 19 2010| Filed Under » Bonds, Economics, Retirement, Short Selling
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When the economy heads into a tailspin, you may hear news reports of dropping housing starts, increased jobless claims and shrinking economic output. How does this affect us as investors? What do house building and shrinking output have to do with your portfolio? As you'll discover, these indicators are part of a larger picture, which determines the strength of the economy and whether we are in a period of recession or expansion. (For some background reading, check out: A Review Of Past Recessions.)
The Phases of the Business Cycle
In order to determine the current state of the economy, we first need to take a good look at the business cycle as a whole. Generally, the business cycle is made up of four different periods of activity extended over several years. These phases can differ substantially in duration, but are all closely intertwined in the overall economy.
Peak - This is not the beginning of the business cycle, but this is where we'll start. At its peak, the economy is running at full steam. Employment is at or near maximum levels,gross domestic product (GDP) output is at its upper limit (implying that there is very little waste occurring) and income levels are increasing. In this period, prices tend to increase due to inflation; however, most businesses and investors are having an enjoyable and prosperous time.
Recession - The old adage "what goes up must come down" applies perfectly here. After experiencing a great deal of growth and success, income and employment begin to decline. As our wages and the prices of goods in the economy are inflexible to change, they will most likely remain near the same level as in the peak period unless the recession is prolonged. The result of these factors is negative growth in the economy.
Trough - Also sometimes referred to as a depression, depending upon the duration of the trough, this is the section of the business cycle when output and employment bottom out and remain in waiting for the next phase of the cycle to begin.
Expansion/Recovery - In a recovery, the economy is growing once again and moving away from the bottoms experienced at the trough. Employment, production and income all undergo a period of growth and the overall economic climate is good.
Notice in the above diagram that the peak and trough are merely flat points on the business cycle at which there is no movement. They represent the maximum and minimum levels of economic strength. Recession and recovery are the areas of the business cycle that are more important to investors because they tell us the direction of the economy.
To further complicate matters, not all business cycles go through these four steps sequentially. For instance, during a double dip recession, the economy goes through a recession followed by a short recovery and another recession without ever peaking. (Not everyone hurts during a recession. Learn more in Industries That Thrive On Recession.)
Recession Versus Expansion
Recession is loosely defined as two consecutive quarters of decline in GDP output. This definition can lead to situations where there are frequent switches between a recession and expansion and, as such, many different variations of this principle have been used in the hope of creating a universal method for calculation.
The National Bureau of Economic Research (NBER) is an organization that is seen as having the final word in determining whether the United States is in recession. It has a more extensive definition of recession, which deems the following four main factors as the most important for determining the state of the economy:
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The tricky part about trying to determine the state of the economy is that most indicators are either lagging or coincidental rather than leading. When an indicator is "lagging" it means that the indicator changes only after the fact. That is, a lagging indicator can confirm that an economy is in recession, but it doesn't help much in predicting what will happen in the future. (Learn more about this in Economic Indicators To Know.)
What Does this Mean for Investors?
Understanding the business cycle doesn't matter much unless it improves portfolio returns. What's an investor to do during recession? Unfortunately, there is no easy answer. It really depends on your situation and what type of investor you are. (For some ideas, see Recession-Proof Your Portfolio.)
First, remember that a bear market does not mean there are no ways to make money. Some investors take advantage of falling markets by short selling stocks. Essentially, an investor who sells short profits when a stock declines in value. Problem is, this technique has many unique pitfalls and should be used only by more experienced investors. (If you want to learn more, see the tutorial Short Selling.)
Another breed of investor uses recession much like a sale at the local department store. Referred to as value investing, this technique involves looking at a fallen stock not as a failure, but as a bargain waiting to be scooped up. Knowing that better times will eventually return in the economy, value investors use bear markets as buying sprees, picking up high-quality companies that are selling for cheap.
There is yet another type of investor who barely flinches during recession. A follower of the long-term, buy-and-hold strategy knows that short-term problems will barely be a blip on the chart when taking a 20-30 year horizon. This investor merely continues dollar-cost averaging in a bad market the same way as he or she would in a good one.
[COLOR=#F21C46 !important][/COLOR]
Of course, many of us don't have the luxury of a 20-year horizon. At the same time, many investors don't have the stomach for riskier techniques like short selling or the time to analyze stocks like a value investor does. The key is to understand your situation and then pick a style that works for you. For example, if you are close to retirement, the long-term approach definitely is not for you. Instead of being at the mercy of the stock market, diversify into other assets such as bonds, the money market, real estate, etc.
Conclusion
The financial media often takes on a "sky is falling" mentality when it comes to recession. But the bottom line is that recession is a normal part of the business cycle. We can't say what the best course is for you - that's a personal decision. However, understanding both the business cycle and your individual investment style is key to surviving a recession. (For further reading, check out The Impact Of Recession On Businesses and Profiting In A Post-Recession Economy.)
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by [h=2]Investopedia Staff[/h]
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.
Read more: Recession: What Does It Mean To Investors?
March 19 2010| Filed Under » Bonds, Economics, Retirement, Short Selling
Comments
0
Email
Print
Reprints
Feedback
When the economy heads into a tailspin, you may hear news reports of dropping housing starts, increased jobless claims and shrinking economic output. How does this affect us as investors? What do house building and shrinking output have to do with your portfolio? As you'll discover, these indicators are part of a larger picture, which determines the strength of the economy and whether we are in a period of recession or expansion. (For some background reading, check out: A Review Of Past Recessions.)
The Phases of the Business Cycle
In order to determine the current state of the economy, we first need to take a good look at the business cycle as a whole. Generally, the business cycle is made up of four different periods of activity extended over several years. These phases can differ substantially in duration, but are all closely intertwined in the overall economy.
Peak - This is not the beginning of the business cycle, but this is where we'll start. At its peak, the economy is running at full steam. Employment is at or near maximum levels,gross domestic product (GDP) output is at its upper limit (implying that there is very little waste occurring) and income levels are increasing. In this period, prices tend to increase due to inflation; however, most businesses and investors are having an enjoyable and prosperous time.
Recession - The old adage "what goes up must come down" applies perfectly here. After experiencing a great deal of growth and success, income and employment begin to decline. As our wages and the prices of goods in the economy are inflexible to change, they will most likely remain near the same level as in the peak period unless the recession is prolonged. The result of these factors is negative growth in the economy.
Trough - Also sometimes referred to as a depression, depending upon the duration of the trough, this is the section of the business cycle when output and employment bottom out and remain in waiting for the next phase of the cycle to begin.
Expansion/Recovery - In a recovery, the economy is growing once again and moving away from the bottoms experienced at the trough. Employment, production and income all undergo a period of growth and the overall economic climate is good.
|
Notice in the above diagram that the peak and trough are merely flat points on the business cycle at which there is no movement. They represent the maximum and minimum levels of economic strength. Recession and recovery are the areas of the business cycle that are more important to investors because they tell us the direction of the economy.
To further complicate matters, not all business cycles go through these four steps sequentially. For instance, during a double dip recession, the economy goes through a recession followed by a short recovery and another recession without ever peaking. (Not everyone hurts during a recession. Learn more in Industries That Thrive On Recession.)
Recession Versus Expansion
Recession is loosely defined as two consecutive quarters of decline in GDP output. This definition can lead to situations where there are frequent switches between a recession and expansion and, as such, many different variations of this principle have been used in the hope of creating a universal method for calculation.
The National Bureau of Economic Research (NBER) is an organization that is seen as having the final word in determining whether the United States is in recession. It has a more extensive definition of recession, which deems the following four main factors as the most important for determining the state of the economy:
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- Employment
- Personal income
- Sales volume in manufacturing and retail sectors
- Industrial production.
The tricky part about trying to determine the state of the economy is that most indicators are either lagging or coincidental rather than leading. When an indicator is "lagging" it means that the indicator changes only after the fact. That is, a lagging indicator can confirm that an economy is in recession, but it doesn't help much in predicting what will happen in the future. (Learn more about this in Economic Indicators To Know.)
What Does this Mean for Investors?
Understanding the business cycle doesn't matter much unless it improves portfolio returns. What's an investor to do during recession? Unfortunately, there is no easy answer. It really depends on your situation and what type of investor you are. (For some ideas, see Recession-Proof Your Portfolio.)
First, remember that a bear market does not mean there are no ways to make money. Some investors take advantage of falling markets by short selling stocks. Essentially, an investor who sells short profits when a stock declines in value. Problem is, this technique has many unique pitfalls and should be used only by more experienced investors. (If you want to learn more, see the tutorial Short Selling.)
Another breed of investor uses recession much like a sale at the local department store. Referred to as value investing, this technique involves looking at a fallen stock not as a failure, but as a bargain waiting to be scooped up. Knowing that better times will eventually return in the economy, value investors use bear markets as buying sprees, picking up high-quality companies that are selling for cheap.
There is yet another type of investor who barely flinches during recession. A follower of the long-term, buy-and-hold strategy knows that short-term problems will barely be a blip on the chart when taking a 20-30 year horizon. This investor merely continues dollar-cost averaging in a bad market the same way as he or she would in a good one.
[COLOR=#F21C46 !important][/COLOR]
Of course, many of us don't have the luxury of a 20-year horizon. At the same time, many investors don't have the stomach for riskier techniques like short selling or the time to analyze stocks like a value investor does. The key is to understand your situation and then pick a style that works for you. For example, if you are close to retirement, the long-term approach definitely is not for you. Instead of being at the mercy of the stock market, diversify into other assets such as bonds, the money market, real estate, etc.
Conclusion
The financial media often takes on a "sky is falling" mentality when it comes to recession. But the bottom line is that recession is a normal part of the business cycle. We can't say what the best course is for you - that's a personal decision. However, understanding both the business cycle and your individual investment style is key to surviving a recession. (For further reading, check out The Impact Of Recession On Businesses and Profiting In A Post-Recession Economy.)
by [h=2]Investopedia Staff[/h]
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.
Read more: Recession: What Does It Mean To Investors?
- Several forces affect wages and employment levels through the demand side of the labor market. Well start with three important sources of change and then talk about how they cause the demand curve to shift.
- Change in consumer demand
- Long-term change in labor productivity
- Change in government regulations or taxes which change labor costs
- Consumer demand changes, be it up or down, brings about changes in product price. We have already seen that both TRP (=P*Q) and MRP (=P*MP) are measures of the contribution of labor to the value of a firm. A price decrease, therefore, can result in decreases in TRP and MRP, and will reduce the total profit of a firm. This would result in a leftward shift in the demand for labor curve in a given labor market, as is shown below. The result is downward pressure on wage rates as well as a contraction of employment in that labor market. It is anticipated, as a consequence, that those workers who become unemployed would move to another market where their skills are in demand. However, workers who remain would expect to realize lower wage rates and reduced employment opportunities in this market.
Visual 14.3.4. A Decrease in Labor Demand
- Productivity changes occur over long stretches of time and because of the way they are incorporated into the workplace. Typically the changes are the kind that makes workers more, not less, productive. Sources of productivity improvement include the following.
- Improved skills of workers because they have received better schooling and, consequently learn faster, are better readers and writers, are more skilled at conducting multiple tasks while at work, can more readily train others. Workers also have improved skills because they have received more and better on-the-job training which means they can do their job in a more competent and efficient manner.
- Workers are more productive because the complementary resources with which they work are better and more efficient. For example, a more competent and skilled management and supervisory staff can make workers more productive when workers receive clearer direction from a staff that is visionary and uses a management style that keeps worker morale high. Similarly, workers equipped with efficient capital will be more productive than workers who are not.
- The end result is that greater productivity raises the Q part of TRP and the MP part of MRP. A business is now capable of generating output at lower labor costs, higher profits, and is encouraged to build on the opportunities by expanding output and employment levels. The labor demand curve, in this instance, is moved rightward with a consequent rise in both employment and wage rate levels.
Visual 14.3.5. An Increase in Labor Demand
- Changes in government regulations and taxes directly affecting labor demand.
- Both the imposition of a government regulation as well as taxes has the impact of raising labor costs to a business. Today, the main regulations on a business regarding workers have to do with over time pay, protection of health and safety, use of child labor, and/or requirements to contribute to an unemployment compensation fund. Taxation affecting business and relating to labor include a payroll tax to finance a workers social security and Medicaid accounts. Both the imposition of a regulation and the imposition of a labor-related tax have the effects of moving the labor demand curve leftward. The reason for this type of change is that since both raise labor cost, firms are unwilling to pay the wage rate that existed prior to the imposition of the tax (or regulation) plus the cost of the tax (or regulation). The new demand curve now reflects the added costs imposed by government. The actual wage now received by workers is lower, W1, down from W*, while the wage paid by employers (including the cost of the tax or the regulation) is W2. Therefore, workers receiving a lower wage, fewer of them are willing to accept it, and the supply of work effort falls to L2. Additionally, because employers now have to pay the wage plus the extra cost, employers will also demand fewer workers. Therefore, both sides of the labor market lose: less output and less employment, with firms facing higher labor costs, and workers receiving lower wages. The government gains if the extra cost comes in the form of a tax; the industry supplying the extra goods/services to bring firms in compliance with the new regulation gain, if the extra cost comes in the form of a regulation.
- Symmetrically, forces at work bring about additions or subtractions to labor supply and therefore would displace the supply curve rightward or leftward. Let us consider a few of such forces and their effects.
- A population growth that produces a change in the size of the labor force
- Changes in preferences toward labor market work
- Changes in time in school and in training
- Changes pension plans and disability insurance programs
- Changes in the age composition of the work force.
- Let us first see how population changes affect labor supply. Population change is attributable to changes in birth rates, death rates, and immigration rates. Increases in immigration rates and birth rates, and decreases in death rates add to the population and over time to the nations size of the labor force. The joint or single influence any these movements move the labor supply curve to the right. This is shown in the diagram below.
Visual 14.3.6. An Increase in Labor Supply
- Alternatively, a leftward shift in the labor supply curve would be the result of a declining birth rate and immigration rates, and increases in death rates. This is shown below.
Visual 14.3.7. A Decrease in Labor Supply
- Evident in both cases is that wage rates change with such developments in the labor market. Similarly, assume that the entire population or segments of the population developed a greater taste for market goods, and correspondingly, a greater desire to enter the labor force. This shift in preferences would have the effect of moving the labor supply curve rightward. This is precisely the development referred to earlier that occurred in the female population which has represented a rapid growth in the attachment of females to the world of work. To the contrary, a labor force that rapidly ages would bring about a decrease in labor supply. The provision and availability of pension plans would decrease the labor supply as would the provision and availability of disability insurance workers.
- Several forces affect wages and employment levels through the demand side of the labor market. Well start with three important sources of change and then talk about how they cause the demand curve to shift.
