Investing in Equity Markets During a Recessionby Eric Petroff
Consider the macroeconomic issues of a recession and how they affect capital markets. When a recession hits, companies slow down business investment, consumers slow down their spending, and people's perceptions shift from being optimistic and expecting a continuation of recent good times to becoming pessimistic and uncertain about the future. As such, people get understandably frightened, become worried about prospective investment returns and rationally scale back risk in their portfolios. The results of these psychological factors manifest themselves in a few broad capital market trends. Within equity markets, the results are pretty obvious. As people become uncertain about prospective earnings, they perceive a greater amount of risk in their investments, which broadly leads investors to require a higher potential rate of return for holding equities. Of course, for expected returns to go higher, current prices need to drop, which occurs as investors sell their higher risk investments and move into safer securities including government debt. This is why equity markets tend to fall, often precipitously, prior to recessions as investors shift their investments.