Every economic cycle has its ups and downs. But how can you tell when there’s merely a lull in the action, or something more serious?
We’re talking about the difference between market downturns and recessions. While day-to-day market activity is generally different from what’s going on in the economy, a serious drop in markets can trigger an economic recession as well. Read on and we’ll break down the relationship between the two.
What is a market downturn?
Market downturns occur when key market indexes such as the S&P 500, the Dow Jones Industrial Average, or the Nasdaq drop. Decreases in the value of these indexes don’t necessarily indicate a decline in economic activity, however, and they can turn around fairly quickly.
Markets can drop in reaction to the news cycle and political events in the short run, but they can also react to longer-term situations, such as changes to interest rate, companies or consumers taking on too much debt, and investor speculation, which can result in a run up of stock prices, also known as a stock bubble.
Though market drops can be short-lived, a severe downturn, such as a bear market, can last months, or even years. In such cases, market downturns are likely to be associated with economic downturns and recessions.
What’s a recession?
A recession is an extended period of economic contraction. It’s often said that a recession occurs when the economy experiences two consecutive quarters—or six —of negative GDP growth. In other words, the economy isn’t growing, but shrinking.
Shifting market indicators such as rising unemployment, falling GDP, and lower consumer spending, can signal an economic downturn, or a budding recession.
While the stock market typically falls during recessions, the market activity doesn’t necessarily determine whether or not the economy is in a recession. Because recessions are classified by economic growth, it’s possible to have markets trend upward while the economy is still in a recession.
Market downturns can lead to recessions, however. For example, a market downturn can cause significant decreases in capital, or money, available to both consumers and companies. As a result, companies may lay off workers, who will then have less money to spend, save, and invest.
More about recessions
The shortest recession on record (1980) lasted only six months, according to federal data stretching back to the 1850s. In contrast, a recession that started in 1873 lasted 65 months, or nearly five and a half years.
The Great Recession, which had its roots in the housing mortgage market, was triggered by the collapse of investment bank Lehman Brothers. The bank’s collapse sparked a sudden market downturn, and eventually the collapse of real estate prices. Ultimately, the banking system froze up, requiring a massive government bailout. The financial crisis lasted 18 months, but the fallout from it still lingers today.
What should you do?
Market downturns, bear markets, and recessions are all a part of larger business cycles—the economy experiences periods of expansion and contraction. For investors, that means that they’re simply a part of life, and that there’s no avoiding them.
So, what should you do when a downturn or recession eventually rolls around? Stash recommends staying the course—diversify your portfolio, continue investing regularly, and invest for the long-term.