Recession Fear Drives Traders To Change Strategy

Recession.

Are you afraid?

While scary to many, a recession in the economy isn’t a new or unfamiliar event in the U.S. or the world.

This offers little comfort to consumers and traders who feel battered from the effects of a two-year pandemic, a Eurocentric war, escalating prices of goods, and impending interest rate hikes. Looming recession fear has a psychological effect on traders which transfers in the form of volatility into the stock market.

When will a recession begin?

There is a wide debate about what causes a recession, and no one can determine the “moment” a recession begins. A variety of factors contribute to a state of the economy that sets off a recession.

For traders, the events leading into a recession can cause panic in the stock market and global economy. This can be a dangerous time for unprepared traders and lead to losses in trading accounts.

The U.S. has experienced 34 recessions since 1854 with the most recent one occurring in 2020 (pandemic induced). Since 1980, the U.S. has experienced five periods of negative economic growth that were considered recessions. The most well-known examples include the 2008 financial and housing crisis and the Great Depression of the 1930s (preceded by the Wall Street Crash Of 1929).

The U.S. fell into a recession during the coronavirus pandemic that began in the first quarter of 2020. This recession was the shortest on record ending only two months later in April of that same year.

Often the term recession is associated with a longer period of economic distress – a depression. They are technically not the same. A depression is a deep and long-lasting recession.

No specific criteria exists to declare a depression, but the Great Depression included a decline of 33% in the quantity of goods and services produced in the United States, an 80% loss of value in the stock market, and an unemployment rate that briefly touched 25%. A depression is a severe decline that can last for many years.

What causes a recession?

Trying to pinpoint what causes a recession is complicated.

According to several economists, there are some generally accepted predictors that can occur at the same time and point to a possible recession. Leading indicators historically show changes in market trends and economic growth rates before corresponding shifts in macroeconomic trends.

The accepted definition of a recession is two consecutive quarters of negative economic growth as measured by the gross domestic product (GDP). That being said, quarterly declines in GDP do not always align with the decision to declare a recession.

Some economists believe that real changes and structural shifts in industries best explain when and how economic recessions occur. For example, a sudden, sustained spike in oil prices due to a geopolitical crisis might simultaneously raise costs across many industries.

Some Wall Street banks are forecasting an eventual economic recession as a result of the Russian war in Ukraine, record highs in inflation, and an increasingly hawkish Federal Reserve.

Others point to the rising cost of diesel as a flashing indicator of a nearing recession. The fuel is heavily used by farmers, truckers, and construction workers. The national average is now at a record high of $5.32 a gallon, which is an increase of 40% from a year ago.

A variety of economic theories have been developed to explain how and why recessions occur.

Recessions are visible in industrial production, employment, real income, and wholesale-retail trade. Analysts refer to official data from government agencies. This data represents key sectors of the economy, such as housing and capital goods. Lagging indicators, such as a rise in unemployment rates, are also used to confirm an economic shift into recession.

Recession is an unpleasant, but normal, part of the business cycle. Business cycles are marked by the alternation of the phases of expansion and contraction in the collective economy.  Recessions are characterized by failures of several businesses and banks, slowed or negative growth in production, and high unemployment numbers.

Even though temporary, the economic pain caused by recessions can have major effects that alter an economy for years, even decades. As the economy shifts structurally as vulnerable or obsolete firms, industries, or technologies fail, dramatic policy responses by the government can literally rewrite the rules for business.

Watching out for a recession ahead

Traders at Simpler Trading have been discussing a potential recession ahead.

“Talks of a recession are circling and it’s scary,” according to John Carter, Founder of Simpler Trading.  “With that though, in the short term I’m looking for a small bounce and for the market to roll over.”

Current market and economic conditions reveal that recession does sound possible. Last quarter the U.S. GDP was -1.4%, according to government reports. The expectation was that GDP would grow by 1% for the quarter. When analysts see two GDP reports in a row that are negative, then a recession is highly probable. The lagging trend in the GDP appears to be continuing into the second quarter.

John thinks it’s possible for the hawkish Central Bank (Fed) to complicate recovery.

“I think the Federal Reserve is panicking that they are behind the curve so they could overcorrect on rate increases and put us into a recession,” according to John. The economy is still very strong at the moment, he said, which may complicate any actions by the Fed.

As expert traders who are in the markets daily, Simpler traders have been consistent as they anticipate the market to continue to roll over following each bounce. This has resulted in strategic trading to the downside rather than “buying-the-dip.”

There is significant weakening in the markets right now.

Three main areas are being affected – U.S. bonds, the Yen (Japanese currency), and technology stocks.

U.S. bonds have had the biggest decline in decades followed by the Yen.

National news reports are showing that investors find it confusing when a rising interest rate causes a market decline. However, publicly traded funds reflect the market value of the securities they hold, and the value of many bonds has been dropping. (Rising yields may eventually benefit bond fund investors.)

Futures traders are finding that Yen is inverted. This can make traders pause to consider that six months from now a fund may blow up that used the Yen as a carry trade (when an investor borrows at a low-interest rate and then reinvests that money into a financial asset offering a rate of return higher than the borrowed interest rate).

Technology stocks dropped in price on the idea that these assets are losing the trust of investors. One market assumption is that of an inverse relationship between tech stocks and interest rates. While most Big Tech stocks are not particularly sensitive to interest rate changes, their company valuations are sensitive to rising interest rates. Higher rates mean lower present values and lower stock prices.

If “strong” stocks of the past can’t be trusted, where do people go?

Traders often consider gold or silver as a safe resort against market concerns.

This fear of the markets and “run” for precious metals can be a multi-year process.

Consider that when interest rates go as high as they are right now the increase affects billions of dollars in investments. Interest rates were at almost 1% a year a year ago, and now they’re at 3%. Would traders rather hold onto a steady 3% return or put money in a now volatile technology stock?

All of these factors are combining to affect what is happening in the markets. As interest rates continue to go higher, traders can anticipate more weakening of technology stocks.

Recessions hard to predict

One thing is certain, this will not be a dull year for traders thanks to all the recession factors in play, but no declared recession.

While the Fed has intervened in the bond market, it has less influence over longer-term bonds – five, 10, or 30 years. These yields haven’t risen as rapidly as those for shorter-term securities.

Some shorter-term rates have already exceeded the rates for longer-term bonds. When that happens, there is a yield-curve inversion. These inversions suggest that traders doubt that the Central Bank will be able to keep increasing interest rates because the economic impact will be too severe.

An inverted yield curve generally signals an impending recession.

With all the fear of a recession, traders should closely watch market signals for changes in the trending direction, structure, or momentum.

Some recession theories explain recessions as dependent on financial factors. This can be  the overexpansion of credit and financial risk during the good economic times preceding the recession or the contraction of money and credit at the onset of recessions – or both.

There are also psychology-based theories of recession that look at the excessive exuberance of the preceding economic “boom” or the deep pessimism to explain why recessions occur… and even persist.

It has been suggested the pessimism of investors can become a self-fulfilling prophecy of curtailed investment spending. This can then lead to decreased incomes that reduce consumer spending.

Using stock scanners and chart indicators allows traders to find the “diamonds in the rough” as potential trades are setting up.

Simpler traders adjust strategies to look for setups for the squeeze whether a stock is moving in a bullish or a bearish direction. Traders will find these setups tend to gravitate toward company stocks with strong balance sheets and will generally avoid those that are highly leveraged, cyclical, or speculative.

Simpler’s traders are trading cautiously using the most current data while relying on charts and indicators to determine if, or when, a recession “officially” begins.

Should recession fears come to fruition, traders should adjust strategies to find setups for that market environment. Traders should then continue to monitor indicators for when the economy will move back in the other direction. The post-recession environment is typically marked by low interest rates and rising growth.

No matter the market environment, traders should adjust trading strategies according to what the market reveals.