How Does a Slowdown In Economic Activity Affect Your Trading?

That's a problem for traders, but there are strategies that investors can use to increase the likelihood that they emerge unscathed from a downturn. Read on to learn what a slowdown in economic activity looks like, what causes it, and what investors can do to minimize their downside risk.

Takeaways

• What influences economic activity

• Why your trades are impacted by economic activity

• How to protect yourself from a downturn

What Is a Slowdown in Economic Activity?

In mid-July 2022, stock markets tumbled following the news that a recession was imminent in the United States. Inflation was rampant, and further interest rate hikes by the Fed were expected to help curb rising prices. Bad news like this causes investor sentiment to turn negative, which causes an economy to grind to a halt. Uncertain how companies will fare during a period of slow or no growth, investors turn to alternative investments like gold or collectibles, which aren't correlated with market movements.

On the ground, a slowdown is characterized by decreased production, fewer business transactions, and rising unemployment because manufacturers have less capital to fund their operations. As investors pull back on stocks, companies have less money to hire workers and produce goods, and consumers have less money in their pockets to buy products and services.

An economic slowdown can and does occur in both weak and strong economies and even if there is no recession in the technical sense. When a recession looms, it's a downward spiral, sometimes made worse by central bank reactionary policies.

What Causes an Economic Slowdown?

The central banks can exacerbate an economic slowdown through their fiscal policies. When inflation is rampant and pushing up prices, typical Fed fiscal policy is to raise interest rates.

Inflation occurs when consumers have too much money but not enough goods. For example, the current housing market is soaring, with many buyers priced out of the market. By raising interest rates, the Fed makes it more difficult for people to borrow money and obtain mortgages so that the supply of houses will go up and the prices will go down. It is a way to slow down spending.

The problem, however, comes if interest rates rise too high. In that case, economic growth will slow because investors and manufacturers fear that people will stop spending. This, in turn, causes unemployment, reducing consumer spending even more and causing stock prices to plummet.

But it would not be right to blame an economic slowdown on central bank and government policies. The private sector can spur a slowdown just as easily. While the expectation of a rise in interest rates, taxes, or a reduction in public spending may be sufficient to reduce stock prices, the private sector can have the same effect by creating market inefficiencies through biased investing.

Investors are attracted to sectors, companies, or industries that have done well for a period, causing the stock prices of these companies to surge. Take the "FAANG" growth stocks—Meta (formerly known as Facebook), Amazon, Apple, Netflix, and Alphabet (GOOG). Some argue that the market prices of these stocks have been far above their intrinsic value. Eventually, the bubble pops.

Consumers and The Business Cycle

At its peak, an economy is running at full steam. Employment is at or near maximum levels, companies are producing, and GDP grows at a healthy rate. Because consumers have jobs and more money in their pockets, they spend more, so manufacturers increase prices. This economic activity (inflation) stimulates investment and pushes up share prices. At least for a short time.

At some point, a downturn is triggered. It could be due to a supply shock due to a pandemic, war, or a correction in overheated asset prices. But when it occurs, investors pull their money out of the stock market, causing wild swings in stock prices. Companies react by pulling back on production and reducing the number of workers on payroll. As people lose their jobs, consumer spending contracts even further.

Then, at some point, output and employment bottom out, investors decide to jump back in and buy cheap stocks, companies begin to reinvest in assets and workers, employment improves, and consumers, once again, begin to spend. And the whole business cycle begins again.

What Can Investors Do About Slowdowns in Economic Activity?

Economic slowdowns are inevitable, but there are strategies investors can use to reduce their risk over the long term.

Build a Diversified Portfolio

A diversified stock portfolio is your best defense against an economic downturn. Owning a variety of stocks from a wide range of sectors is sensible, particularly if you consider using correlation ratios.

Usually, when one type of stock goes up, another will go down. A correlation ratio of +1 indicates two assets moving in perfect positive correlation to each other. A correlation ratio of -1 indicates that they are synced but correlated negatively. They are moving in opposite directions. Including negatively correlated stocks can balance out a portfolio.

During COVID, stocks like Etsy and Doordash thrived while hospitality and hotel stocks tanked. Other ways to diversify are to include bonds, alternative assets, and a 401(k) in a portfolio.

Short Sell Stocks

Short selling stocks is one way to profit from a impending downturn. Traders make money by betting that stock prices will fall in a bear market. When shorting, a trader borrows stocks, uses them or sells them at their current price and then buys them back later at a lower price and returns them to the owner, pocketing the difference.

The practice is risky because if the stock goes against the investor and goes up, there is no limit to how high the price will go, and the investor is forced to buy back the stock at the higher price.

Value Investing

Value investing is buying undervalued stocks. When a recession is expected, panicky investors sell off stocks at a low price, making them "value" stocks. Investors who buy these value stocks stand to capitalize when the market turns bullish once again.

Buy and Hold With a 20 to 30-year Time Horizon

A buy-and-hold long-term strategy is designed to ride the ebbs and flows of the business cycle. Remember that investors don't lose any money on investments until they sell them, so don't. One of the worst times to sell stock is during a downturn because investors will likely have to sell at a loss. Investors who follow a buy-and-hold strategy wait out the downturn until the markets recover. Those that do tend to have the most success.

Try Alternative Assets

During downturns and recessions, investors have historically turned to bonds, gold, or cash instead of volatile stocks. Crypto and sustainable investing are also alternatives to traditional investments, as are collectibles like art, wine, whisky, luxury watches, and sports cards. These assets are not correlated with market events. However, they are riskier and better off used as an addition to an already diversified portfolio.

Conclusion

The best answer to the question "How Does a Slowdown in an Economic Activity Affect Your Trading?" is that it shouldn't. The wise trader accepts the business cycle and builds in strategies to help them ride the ebbs and flows.

Fundamentally, your trading strategy should have built-in risk management mechanisms that suit your trading style and risk tolerance, such as diversification, value-investing, short selling, alternative investing, and buy and hold.

There really is no way to control the events that will trigger a downturn or to know which assets will gain and which will suffer. But what you can control is your mindset, so learn as much as you can about investing, choose what you think is the best path, and stick to it regardless of the market chaos. The most successful investors are the ones that follow data and logic, not emotion.