India is a developing country that undergoes phases of economic growth as well as slowdowns. While the economy is scaling new heights, there are times when it enters a slow phase too. The most recent example of this is the COVID-19 pandemic. While the pandemic had a global effect, it caused serious economic repercussions for India too. Talking about the Indian stock market, the onset of the pandemic led to a considerable crash. Both the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) fell by 38%. This constituted a fall of 27.31% from the beginning of 2020.
Besides a crisis or a pandemic, the Indian stock market is affected by a lot of external factors, both domestic and international. One such factor is the economic recession that has an adverse effect on the Indian stock market. Let’s understand how but before that, let’s get familiarised with the basics.
What is recession?
Recession is defined as a slowdown in the economic activities of a country. This slowdown might last for two or more quarters and cause a fall in a country’s Gross Domestic Product (GDP). Besides the GDP, other economic indicators, like corporate profits, employment opportunities, and more, also suffer a decline.
Industrial activities and trading are reduced in a bout of recession. This ultimately leads to a reduction in the overall GDP.
Many investors confuse a recession with depression, which is a much more severe scenario. Let us understand how the two are different.
Recession v/s depression – the difference
While both terms are used for a declining economy, a recession is different from a depression in many respects. As a famous line goes, ‘it’s a recession when your neighbour loses his job, but a depression is when you lose yours’.
Recession and depression differ from one another on the basis of their severity and duration. A recession is less severe than a depression. It is indicated by a downtrend in trend in business cycles, unemployment, and a decrease in production and trading activities. This phase can last for several months. For households, recession leads to reduced purchases and investments.
Depression, on the other hand, is a far more serious situation. It involves considerably reduced production and industrial activities, widespread unemployment, a significant decrease in international trade, and depleted capital movements. Depression usually lasts for longer periods of time because recovering from one is far more challenging.
Another difference between recession and depression is the geographical impact. Recession might be a country-specific phenomenon, while depression usually involves two or more countries and can have a global impact.
Despite being a fairly short-termed phenomenon, recession leaves its impact on the stock market. Let us see how.
The impact of recession on the stock market
The Indian stock market is closely correlated with the Indian economy. As such, any impact on the economy is closely felt by the stock market too.
Recession has a considerable impact on the Indian economy. If the economy slows down, there is an adverse effect on the stock market. This can be seen in two ways:
Fall in the stock market
Recession means a falling economy which, in turn, causes the stock market to fall too. There are reduced commercial operations, limited disposable income in households, and reduced demand, all of which pushes the stock market down. Furthermore, market sentiments turn negative, and a bearish trend prevails.
Another thing to note is that a recession in one country not only impacts its domestic stock market but has an international effect.
The 2008 financial crisis is a leading example of this. The recession that started in the United States caused a stock market crash in India. The crisis was triggered when a housing market bubble that was formed burst. After a series of reckless lending, when it was time to pay back the loans, people started defaulting. This led to multiple banks failing, credit tightening, and global trade declining. From what started in the US, the massive economic shock resulted in a ripple effect across the globe, with economies slowing down worldwide. The Dow Jones index was at a historical low on 19th September 2008. Just as the stock market in the US fell, the Indian exchanges saw a similar fate.
As the market falls, there is also a marked increase in stock market volatility as long-term investors as well as traders look out for reduced stock prices to add quality stocks to their portfolios. If there are too many buyers, the buying pressure on the stock might temporarily increase its price. This increased volatility makes the stock market swing unpredictably, making stocks an unfavourable choice for many.
Now that we understand the impact of recession, let us explore the reasons behind one of its major consequences – the fall in the stock market.
Why does the stock market fall?
The stock market falls during a period of recession due to several factors. These include:
Reduced household incomes
Recession leads to increased unemployment and a lack of business opportunities for the self-employed. Because of this, the income of households reduces; however, the expenses might not. This further leads to a reduced disposable income, which is the income left with a household after paying all expenses.
Individuals find it difficult to save and invest their limited income. As the disposable income reduces, so does the possibility of investments. This, in turn, reduces the demand for buying stocks. As demand falls, the stock market suffers a fall too.
Reduced corporate activity
In a recession, businesses reduce their commercial activities to lower costs. As activities are reduced, investors become sceptical about the company’s performance, and the market price of the stock might take a tumble. If several businesses reduce their corporate activities, the overall market index is affected adversely and suffers a fall.
Reduced profitability of companies
Reduced demand, reduced corporate activities, and a lull in the economy is counterproductive for business profits. While the revenue of the organisation takes a hit, the expenses continue. This reduces the profitability. Companies with reduced profitability might attract negative market sentiments causing their stock prices to fall. If the stock prices of multiple companies fall, the overall stock market suffers.
Nil or reduced dividend income
Companies with limited or negative profits do not declare dividends. Even if they do, the rate might be reduced. This further makes their stocks unfavourable as investors do not see the possibility of a dividend income on their investment.
Now that you understand why the market goes down during a recession, it is crucial that you strategise accordingly to mitigate your losses. Let us see what you can do during a recession.
What to do in a recession?
Though recession can lead to a fall in the stock market, the situation is not permanent. If you are an intraday trader, you would need to monitor the market closely to spot short-term trading opportunities. Since the market remains highly volatile, you can cash in on a sudden upswing.
However, for long-term investors, patience is key. You would have to exercise caution with your holdings. If you have invested in quality stocks, they will give you returns in the long term when the economy is out of recession. Meanwhile, do not panic.
Here are some other tips for stock market investors when the economy is in a recession –
- If you have sufficient savings at your disposal, invest in quality stocks when their prices are low. You can get a good quantity of the stock at reduced prices and then earn returns when the stock recovers.
- Hold on to your investments. Do not consider liquidating the portfolio. The stock market always recovers after a lull, and when it does, your portfolio can fetch you attractive returns.
- Have a diversified portfolio of stocks. Some stocks might give you returns even in a recession.
- You can also consider investing in a readymade basket of securities. Teji Mandi offers two such portfolios that have fetched excellent returns over the years. The Teji Mandi Multiplier portfolio comes with a CAGR of 93%, and the Teji Mandi Flagship portfolio gives a CAGR of 56%. These portfolios contain a diverse range of handpicked stocks that give you the benefit of all-weather investing.
- Seek professional help for managing your portfolio.
To get an insight into what to do during the bearish trend that comes with a recession, read our article on ‘how to control your greed in a bull market and gain confidence in a bear market’ on the Teji Mandi blog.
Recession, though not permanent, is a phase that takes a hit on the economy and the stock market as well. While it is rare, it is a possibility. So, if you invest in stocks, it is vital for you to know the impact of recession on the stock market. Also, you must learn to manage your portfolio wisely so that short-term phases do not affect your long-term investment goals and strategies.
Teji Mandi is a Sebi-Registered Research Analyst that keeps track of your investments and helps you build a portfolio that suits your risk profile. Reach out to us for help regarding stock insights and for tips to manage your investments during a recession.