So, recent headlines tell us what we already know: the UK is in recession. It’s terrible news but if you’re currently investing money on the FTSE, I don’t think you should be too concerned. This is because stock markets are generally forward-looking.
We’ve known for a while that a recession was highly likely due to the economy-halting success of the lockdown. Indeed, the stock market adjusted for the upcoming bad news back in the spring, resulting in the market crash. Yesterday’s GDP figures only confirmed the UK’s recession retrospectively.
To highlight this, the FTSE 100 climbed 2% on the same day!
However, if you are investing money, be aware that cyclical, highly leveraged and speculative stocks don’t usually perform well in a recession.
Cyclical stocks
Cyclical stocks are so-called because they follow economic cycles. If the economy is doing well, people pay money for cyclical goods, such as expensive coffees, foreign holidays, and new cars. In a recession, people cut back on these same goods because they’re not essentials. This lowers revenues, profit margins, and by extension the share prices, of the companies concerned.
Conversely, adding less volatile counter-cyclical, or defensive, stocks to a portfolio should help provide more stable earnings and dividends throughout the downturn. These stocks include utilities, discounters, and consumer staples such as food or tobacco.
However, seasoned investors may look for bargains among cyclical stocks in companies with healthy cash flows and solid business models, to see them through bad times. For beginners investing money, though, I’d advocate avoiding cyclical stocks altogether.
High leverage
Companies with high amounts of debt will likely have large interest charges to pay. This stops its money from being used for other things, such as short-term liquidity for survival.
When combined with the lowering revenues prevalent in a recession, higher debt makes a firm more vulnerable to any credit tightening. The risk of bankruptcy increases.
Investing money in speculative stocks
Even great companies present investors with high-risk opportunities when they’re overpriced. The prices of these firms reflect investors’ future optimism for them. However, at least established firms with good records have something tangible to base this optimism on.
Investing money in speculative stocks is a different ball game. These stocks promise to be the ‘next big thing’ and are often the result of market bubbles. The price is based on pure optimism as to whether an idea can work.
These volatile ‘under-the-radar’ opportunities often quickly fall in price during a recession as investors find safer assets elsewhere.
Stocks with one or more of the above characteristics increase your risk of losing money in a recession.
Knowing which shares make good investments is not enough to stop any losses in hard times. It’s also essential to understand which stocks to avoid if you want to maximise shareholder returns. Losing money from bad investments can more than offset the gains from good ones.
