Recession: What Does It Mean To Investors?

by Investopedia Staff, (Investopedia.com) (Contact Author Biography)

When the economy heads into a tailspin, you may hear news reports of dropping housing starts, increased jobless claims and shrinking economic output. How does this affect us as investors? What do house building and shrinking output have to do with your portfolio? As you'll discover, these indicators are part of a larger picture, which determines the strength of the economy and whether we are in a period of recession or expansion.

The Phases of the Business Cycle

In order to determine the current state of the economy, we first need to take a good look at the business cycle as a whole. Generally, the business cycle is made up of four different periods of activity extended over several years. These phases can differ substantially in duration, but are all closely intertwined in the overall economy.

Peak - This is not the beginning of the business cycle, but this is where we'll start. At its peak, the economy is running at full steam. Employment is at or near maximum levels, gross domestic product (GDP) output is at its upper limit (implying that there is very little waste occurring) and income levels are increasing. In this period, prices tend to increase due to inflation; however, most businesses and investors are having an enjoyable and prosperous time.

Recession - The old adage "what goes up must come down" applies perfectly here. After experiencing a great deal of growth and success, income and employment begin to decline. As our wages and the prices of goods in the economy are inflexible to change, they will most likely remain near the same level as in the peak period unless the recession is prolonged. The result of these factors is negative growth in the economy.

Trough - Also sometimes referred to as a depression, depending upon the duration of the trough, this is the section of the business cycle when output and employment bottom out and remain in waiting for the next phase of the cycle to begin.

Expansion/Recovery - In a recovery, the economy is growing once again and moving away from the bottoms experienced at the trough. Employment, production and income all undergo a period of growth and the overall economic climate is good.

Notice in the above diagram that the peak and trough are merely flat points on the business cycle at which there is no movement. They represent the maximum and minimum levels of economic strength. Recession and recovery are the areas of the business cycle that are more important to investors because they tell us the direction of the economy.

To further complicate matters, not all business cycles go through these four steps sequentially. For instance, during a double dip recession, the economy goes through a recession followed by a short recovery and another recession without ever peaking.

Recession Versus Expansion

Recession is loosely defined as two consecutive quarters of decline in GDP output. This definition can lead to situations where there are frequent switches between a recession and expansion and, as such, many different variations of this principle have been used in the hope of creating a universal method for calculation.

The National Bureau of Economic Research (NBER) is an organization that is seen as having the final word in determining whether the United States is in recession. It has a more extensive definition of recession, which deems the following four main factors as the most important for determining the state of the economy:

1) Employment 2) Personal income 3) Sales volume in manufacturing and retail sectors

4) Industrial production

By looking at these four indicators, economists at the NBER hope to gauge the overall health of the market and decide whether the economy is in recession or expansion.

The tricky part about trying to determine the state of the economy is that most indicators are either lagging or coincidental rather than leading. When an indicator is "lagging" it means that the indicator changes only after the fact. That is, a lagging indicator can confirm that an economy is in recession, but it doesn't help much in predicting what will happen in the future. (Learn more about this in Economic Indicators To Know.)

What Does this Mean for Investors?

Understanding the business cycle doesn't matter much unless it improves portfolio returns. What's an investor to do during recession? Unfortunately, there is no easy answer. It really depends on your situation and what type of investor you are. (For some ideas, see Recession-Proof Your Portfolio.)

First, remember that a bear market does not mean there are no ways to make money. Some investors take advantage of falling markets by short selling stocks. Essentially, an investor who sells short profits when a stock declines in value. Problem is, this technique has many unique pitfalls and should be used only by more experienced investors. (If you want to learn more, see the tutorial Short Selling.)

Another breed of investor uses recession much like a sale at the local department store. Referred to as value investing, this technique involves looking at a fallen stock not as a failure, but as a bargain waiting to be scooped up. Knowing that better times will eventually return in the economy, value investors use bear markets as buying sprees, picking up high-quality companies that are selling for cheap.

There is yet another type of investor who barely flinches during recession. A follower of the long-term, buy-and-hold strategy knows that short-term problems will barely be a blip on the chart when taking a 20-30 year horizon. This investor merely continues dollar-cost averaging in a bad market the same way as he or she would in a good one.

Of course, many of us don't have the luxury of a 20-year horizon. At the same time, many investors don't have the stomach for riskier techniques like short selling or the time to analyze stocks like a value investor does. The key is to understand your situation and then pick a style that works for you. For example, if you are close to retirement, the long-term approach definitely is not for you. Instead of being at the mercy of the stock market, diversify into other assets such as bonds, the money market, real estate, etc.

Conclusion

The financial media often takes on a "sky is falling" mentality when it comes to recession. But the bottom line is that recession is a normal part of the business cycle. We can't say what the best course is for you - that's a personal decision. However, understanding both the business cycle and your individual investment style is key to surviving a recession.

Bond Yield Curve And The Stock Market

By Hans Wagner on May 25, 2009 More Posts By Hans Wagner Author's Website

Will the steeper yield curve and higher interest rates have a negative affect on stock prices? During the week of May 4, 2009, the U.S. Treasury conducted a record $71 billion May refunding that required higher rates than expected to complete. In fact, the 10-year yield completed its seventh straight weekly rise, a move that has not happened in five years. A steeper yield curve means companies selling longer-term corporate bonds must pay more for the privilege. It shows that interest rates affect investors in the stock market.

Background on the Yield curve One of my first papers I had to write in college was on the “Term Structure of Interest Rates”. The purpose was to discuss how interest rates change over a time and how to interrupt the rates of different maturities at a point in time. I am not sure I understood what I was writing at the time. Since then it has become much clearer and the term “yield curve” provides a much better image in the mind.

The yield curve is a plot of the yield on bonds with the same credit quality across different maturities. The basic assumption is you get more interest on your investment in a bond by holding it longer. The theory states there is more risk for holding a bond for 10 years than for 5 years, or for 5 years than for 90 days. Simply, the yield curve is a graph showing bond yields on the vertical axis and different length maturities of any type of debt instrument such as government bonds and notes on the horizontal axis.

Generally, the longer the maturity of the debt an investor is buying, the greater the yield any given bond will carry. This is because there is more risk to principal the longer the maturity of the debt. The more risk an investor carries, the higher return he should expect.

There are four ways to describe the yield curve at any given time: normal, steep, flat, and inverted. When the economy is growing normally without any fear of inflation or other economic disruptions, the yield curve slopes gently upward. Investors who risk their money for longer periods expect to get a bigger reward in the form of higher interest than those who risk their money for shorter periods. This creates a normal sloping yield curve.

A steep curve occurs when the longer-term bonds have much higher yields than the short-term notes. Investors have a greater fear that inflation is rising, which causes interest rates to be much higher at longer maturities.

The yield curve is flat when there is little difference between the long and short-term securities. This tends to take place when the economy is in transition and the yield curve is forecasting the change. A flat yield curve is normally a temporary situation.

An inverted curve takes place when the rates received on long-term bonds are less than the rates received short-term notes. When the economy is expected to go into a recession, especially a severe one, investors will settle for lower yields now if they think rates and the economy are going even lower in the future. They are betting that this is their last chance to lock in rates before the bottom falls out.

The shape of the yield curve can help tell us the trend in interest rates. Since longer-term rates are much higher, a steep yield curve tells us that the market is expecting rates to increase in the future. Investors want to be protected from loosing current principal value, so the market is generally selling the longer-term bonds. Rates move opposite bond prices. Therefore, when investors sell longer-term bond, rates rise. Rising rates at the long end of the curve hint that inflation is more of a concern.

On the other hand, a flattening or inverted curve, where long-term rates are falling relative to or below the short-term rates, means that the bond market expects interest rates to decline in the near future. This is due to traders bidding up (reducing the yield of) the longer-term bonds because the market expects the higher-yielding bonds to have a higher principal value in the near future. Falling interest rates actually raise the value of the longer-term bonds.

The yield curve only represents the bond market’s expectation of where interest rates and the economy are going, and the bond market, just like the stock market, is never truly efficient. In other words, the yield curve is not exactly perfect in predicting rates and should not be treated as gospel. Nevertheless, the yield curve is as good an indicator as any concerning where interest rates are headed.

Credit Spreads Widening As longer-term interest rates rise, it causes longer-term investment grade credit spreads to widen further. In fact, these credit spreads are currently at or near their widest levels in decades. In some sectors, they are approaching the widest since the Great Depression. This asset class has not been so attractively valued in a very long time. Yields at or around 7% to 8% on investment grade corporate debt are attracting investors who expect equity returns to be low over the next several years. In addition, Treasury yields are now near historical lows, as the Federal Reserve has stepped in to help stimulate the economy with lower rates. Given the current economic environment, corporate profits are likely to grow at roughly the same pace as nominal gross domestic product (GDP). For a variety of reasons, GDP will be below historical trends. In addition, dividends, currently around 3.5% on average, may be cut further to help companies preserve cash. If either or both of these events take place, it will render the equity market far less attractive than investment grade corporate bonds.

The expanding deficits in the U.S. require the Treasury to sell more bonds to provide the money for the government to spend. While still considered a safe investment, investors will require higher rates to meet their return expectations, as we saw in the Treasury auction the week of May 4, 2009. We should expect the treasury yield curve to steepen even further over the next few months. As the Treasury yield curve gets steeper, it will cause the rates of other debt securities to rise, as they must compete for money. Investors should consider what if the ratings on U.S. government securities received less than the best rating.

Affect of Interest Rates on Stock Prices

Bond investors are closely aligned with the economy, as interest rates are a key determinant of economic performance. Stock investors are aware of interest rates, though they focus on companies and their individual performance. As investors, we are very interested in the direction interest rates will go over the next few months and years.

In theory, rising interest rates should be good for stocks. Rates tend to rise when the economy is recovering from a down turn. However, higher rates can also be a determent to an economy that is recovering. That is why the Federal Reserve is keeping short-term rates near zero. However, controlling long-term rates is much more difficult. The hidden hand of Adam Smith steps in and forces all entities to deal with the realities of economics.

When rates go up, many investors seeking safety, who had been buying stocks, opt for bonds to receive their yields tempting. When investors perceive they can get better returns from long-term bonds than from stocks it takes money out of the stock market. This tends to put downward pressure on stocks prices. In addition, companies that sell long-term debt will pay more now that rates are higher. This reduces their earnings power.

As the yield curve gets steeper, it puts downward pressure on stock prices. Like all securities, bond yields do not rise or fall in a direct line. Rather they zig and zag along the way. As the rates for Treasury bonds climbs, they will place downward pressure on stock markets. This is one more factor stock investors need to consider as they make their investment decisions. It does not mean there will not be excellent investing opportunities for equities investors. It just adds to the analysis of the trends for the stock market.

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Famous Failures

"Three Choices that Make You Who You Are" and why they matter.

Three Choices that Make You Who You Are By Adam Khoo One power that has given to us by our creator is the power to choose. The power of free will. I believe that the person you are today is the result of all the choices you have made in the past. Ten years from now, you will definitely become 10 years older. if you are 20 today, you will be 30 and if you are 30 today, you will be 40 a decade from now. The question is who would you have become? What would you have achieved? The answer lies in three major choices that you make every single day. It is what I call the three choices that make you who you are. 1) The People You Choose to Spend Time WithAs social beings, we have the tendency of picking up, matching and following the beliefs, attitudes and habits of the people who surround us. If the people you mix with have negative thoughts, complain all the time and lack self-belief, then the chances are that you will become that way as well. If the people around you constantly think positive, are self-motivated and set high standards, then you will become that way as well. Since we were young, we have been subconsciously picking up the thought and behavioral patterns of the people around us. Haven’t you notice times when you spoke just like your friends or your mother? Have you noticed times when you behaved just like your friends? It is common sense that if you surround a positively charged magnet with 10 negative ones, the positive magnet will soon follow the charges of the rest. This is why there are some people who get all motivated and positive after going for a personal development training but soon go back to their disempowered ways? When they leave the seminar, they go back to a negative environment where people tell them all day that life sucks and that things are hopeless. A seminar can immerse you in a powerful environment for 4-5 days, but the wrong friends will immerse you in a damaging environment for the rest of your life! Let me ask you this think about this… Write down the names of 5 people you spend most of your time with. Now look at these names and ask yourself: Do these people bring out the best in me? Do they inspire me? Do they challenge me? Do they uplift me? Or do these people make me feel lousy and bring me down? Think of the beliefs, attitudes, behaviors and standards that these five people have for themselves. Are these the beliefs that I want for myself? Are these the attitudes that will help me succeed? If the answer is yes, then GREAT. If the answer is no, then it is time you change who you spend time with. If you want to succeed, you have to mix with people who are successful (or who aspire to be successful). If you want to be highly motivated, you have to mix with people who are highly motivated. The main reason why many of the participants from my programs (e.g. Patterns of Excellence, wealth Academy etc…) create powerful and long lasting changes is because of the new friendships that are forged during the program. I have developed and implemented a system where program graduates form into success groups where they keep each other in check and develop a powerful new group culture where wealth and success in the norm. 2) What You Choose to Put into Your MindThe second thing that makes you who you are is what you choose to put into your mind! What are the books you choose to read? What are the magazines you choose to read? When you read the newspapers, which section to you focus on? Which websites do you spend time surfing on? What bookmarks are in your web browser? What seminars do you choose to go to? I often find it very funny when someone tells me that they want to increase their wealth. Yet, they read FHM and sports magazines (instead of SmartInvestor, The Edge and Fortune). They spend their time surfing entertainment sites (instead of moneycentral.com, sgx.com, cnn.com). They read Singapore ghost stories (instead of business & financial books). They rather spend their time and money watching a movie or going on holiday than attending financial management and investment seminar. They input negative thoughts like ‘why am I so poor?’ instead of focusing on thoughts like ‘ how can I learn the strategies to become rich?’ So the second lesson is that if you want to excel in something (e.g. health, success and wealth), you have to invest in your education and learn everything you can about it. Fill you mind with knowledge and thoughts of wealth and you become wealthy. 3) The Dreams You Choose to HavePeople who become better and better every day and move towards their goals do so because they have big and inspiring dreams that fill their minds the moment they open their eyes in the morning. If you have big dreams of becoming the best in your field, building a church/mosque/temple, sending your children to the best schools, buying a landed property, building your own business, then you will live each and every day with passion, focus and a sense of purpose. Every decision you take and every action you take will be purposeful. As a result, you will move closer and closer to you goals every day. However, if you have no dreams that inspire you out of bed. If you have no goals that fill your mind every moment, then you will tend to follow the decisions and actions of others blindly. You will tend to go in all directions with little sense of purpose. You will live your life day by day, without much meaning. And where you will end up 10 years from now will not be by YOUR plan, but by the plan that others have set for you.

BYD: Positioning Berkshire Hathaway for the “Chinese Century”

Warren Buffett is a margin of safety investor. That is, Buffet purchases equity stakes in companies only when he is more or less certain that he won’t permanently lose his capital and where the price is such that he believes he will earn an outstanding return on his investment over time. In order to practice this risk averse method of investing, Buffett has often had to pass on investment opportunities where it was not clear to him how the competitive dynamics of the relevant industry would change over time

During the tech bubble of the 90s, for example, Buffett was derided as being a stodgy old man who simply did not understand the new era of business. However, while Buffett did pass on some outstanding opportunities, he did so because it was difficult for him to predict how these “tech” companies would reinvest capital into their businesses in a way that would maintain or grow their earnings such that the prices quoted for their shares provided a margin of safety. Buffett also knew that the “moats” of many of these companies could easily be crossed by new entrants selling the latest and greatest disruptive technologies and so he declined to participate across the board. This led to a general theory among the press that Buffett simply would not invest in tech companies because he did not understand how these companies worked.

So many Buffett followers were perplexed when he saw fit to buy close to 10% of

BYD Company Limited (BYD), a Chinese manufacturer of rechargeable batteries, mobile handset components, and cars, in October of last year. The purchase was largely viewed in the media as a bet on BYD’s batteries playing a large part in the future of personal transport, either through the sale of its batteries to car manufacturers or through the sale of its own cars. The purchase was also cast as an atypical investment for Buffett, since the company was trying to bring to market a new disruptive technology – namely, a low priced, all-electric vehicle. However, when one digs deeper into the investment, one begins to realize that the investment is vintage Buffett and will, in fact, probably turn out to be one of the best investments that Buffett ever makes in his lifetime. Berkshire’s stake in BYD not only has the adequate margin of safety required by Buffett but also represents the future of Berkshire. Buffett and his partner in crime Charlie Munger are beginning to position Berkshire for what they believe will be the “Chinese Century.”

BYD deals with two businesses: IT manufacturing and auto manufacturing. It has production bases in several large Chinese manufacturing centers as well as in Japan, Korea, Taiwan and various emerging markets (such as Hungary and India). It is a public company and is listed on both the Chinese and Hong Kong stock exchanges. According to a Harvard Business School case study on BYD (required reading, in my opinion, if you really wish to understand Buffett’s interest in the company), the company opened up shop in 1995 and by 2002 became the world’s second largest manufacturer of rechargeable batteries. This was considered a remarkable feat because battery manufacturing was traditionally viewed as a capital intensive business that required large expenditures on things like robotic arms and dry rooms. Chinese companies’ comparative advantage was always thought to be their access to a large supply of cheap labor and so it was assumed that no Chinese company would be able to compete in the battery business. However, BYD was able to become a low cost producer of rechargeable batteries by changing the manufacturing process such that labor became a much larger input and capital equipment became a much smaller input.

BYD also had a one-up on most other Chinese manufacturing companies because it spent far more money on R&D focused on both product improvement and, more importantly, on manufacturing process improvement. This focus on both product and production process engineering is what enabled BYD to become the second largest rechargeable battery supplier in the world so quickly, as the company was able to manufacture batteries in a way that maintained quality control even while relying heavily on human resources for its manufacturing lines. It has also enabled the company to jump into other manufacturing businesses and become the low cost producer over time, as with its entry into mobile handset production. And while turnover on the assembly line side of the business is fairly high, turnover on the intellectual resources side of the business (R&D scientists) is quite low. BYD has been able to keep people on board by offering great benefits, including free housing, food, health insurance, access to free education for their children, and the opportunity to interact socially through athletic events, art programs, etc. In other words, BYD offers its employees Google-like benefits in order to keep them happy and working hard. This is just one of the reasons why BYD has been able to recruit from the “‘top of the top’” in China and why BYD will continue to innovate going forward.

Charlie Munger has called Wang Chuan-Fu a combination of Thomas Edison and Jack Welch, but I believe a more apt comparison for Wang Chuan-Fu is with the titan of American business Henry Ford. Like Ford, Wang started out as a skilled engineer and scientist who actually helped create and design new technological innovations (even working at the Edison Illuminating Company at one point). Like Ford, Wang eventually became a successful entrepreneur that excelled not only in creating innovative and value enhancing products, but also in coming up with new ways to optimize the manufacturing process in a way that made his company a low cost producer. Like Ford, Wang has vertically integrated his company so that it has become a one-stop shop for equipment manufacturing, thus capturing the entire value associated with the manufacturing supply chain. And like Ford, Wang has recognized that it is important for his workers – his human resources – to be taken care of both so that they will be more productive and stay at the company, but also because it is important that they themselves be able to buy the products they are manufacturing. Would you buy into a company run by the Chinese Henry Ford given the chance? I would.

By investing in BYD, Buffett has achieved several amazing feats at once. First, he has bought into a company that could potentially be the lowest cost manufacturer of a number of complex goods, not just batteries, handsets, and cars. BYD initially started out in batteries but then expanded into handsets, LCD screens, and automobiles, and it has always been able to generate profits in these growth enterprises by becoming a low cost manufacturer. BYD’s moat, it seems, comes from the company’s incredible ability to tailor the manufacturing process of complex goods in a way that takes advantage of China’s labor supply advantage. Additionally, BYD has done a good job of fending off competitors by vertically integrating the supply chain, thereby controlling the cost and quality of production and protecting its intellectual property and know-how. According to Wang Chuan-Fu, China is a ruthless place in terms of business competition, and its commercial law is relatively underdeveloped and under-enforced, so it is important that companies adapt their business models to deal with this reality. Learning how business works in China will be much easier with Wang Chuan-Fu at Buffett’s disposal.

Second, by investing in BYD Berkshire has gained access to the largest potential market for goods and services in the world. The growth of China in the coming years will be tremendous, and it is likely that the Chinese will be clamoring for products and service from home and abroad. Mobile phones, LCD TVs, and automobiles are all growth areas where the Chinese can supply themselves if they wish (through companies like BYD), but there are areas where the Chinese will want to purchase from foreigners or open up their markets to foreign investors. For example, the rapid industrialization of China will require huge amounts of electricity, and the Chinese would probably love to work with American utility companies who have expertise in supplying electricity using various types of generating technologies in a way that reduces pollutants and CO2 emissions. This presents a perfect opportunity for MidAmerican, the Berkshire utility subsidiary that made the strategic acquisition of shares in BYD. One can also imagine that the Chinese will increasingly see the social benefits of a robust and healthy private insurance market. By getting a toehold in the Chinese market, making business and political connections there, and learning more about the various risks of doing business in China, Berkshire may eventually be able to provide insurance capacity in China in the manner that it does in the U.S. This will give Chinese citizens access to insurance policies from a company that will always be able to make good on its promises due to its responsible underwriting and healthy investment practices.

Third, Buffet’s investment in BYD will better enable Berkshire to access one of the largest pools of talent in the world. China is continually churning out loads of intellectual talent, particularly in the fields of natural science, engineering, and business, and BYD is a top repository of such talent. Berkshire will be able to access China’s top talent both directly through BYD and through the networks of the individuals working for BYD, including Wang Chuan-Fu, thus allowing Berkshire to be more “linked in” to the Chinese business, scientific, and political communities. This in turn will enable Buffett and his successors to capitalize on new technologies that emerge from Chinese industry and to better understand the business climate in China as it changes. For example, if MidAmerican is deciding on investing in battery storage for its renewable energy portfolio, it can turn to BYD for advice on the appropriate technologies or even be directed by BYD to the companies BYD believes has the best technology for MidAmerican’s purposes. Or if Berkshire is interested in being involved in the development of traditional or renewable generation capacity in China, it can tap into BYD’s talent network to figure out what the regulatory outlook is like in China for allowing foreign investment in utilities.

Finally, given BYD’s growth potential, Berkshire has purchased its stake in BYD for what appears to be an outstanding price. Take a look at BYD’s annual report for 2008. Buffett infused about HK$ 1.8 billion worth of capital into BYD for a purchase price of HK$ 8 per share, resulting in a 10% stake in BYD. Last year, BYD earned RMB 0.50 per share, which is currently equivalent to about HK$ 0.57. Assuming that reported earnings are a good approximation of “owner earnings” and that BYD’s owner earnings will merely be maintained over the business’ lifetime, Buffet’s earnings yield for his stake is close to 7%. This is an excellent price for a company that in actuality has huge growth potential, especially when you consider that much of BYD’s income generating assets are intangible in nature (remember: its production process know-how is what helps it to be the low cost manufacturer).

BYD has a legitimate shot at becoming one of the largest suppliers of electric vehicle-related battery technology in the world given its low cost battery manufacturing capabilities. Furthermore, it is possible – though not necessarily probable – that BYD will become the largest automaker in the world. If BYD succeeds in this respect, it will probably be because its cars present a value proposition for emerging market customers rather than its cars being of the best quality. Regardless, BYD will almost certainly become a major auto manufacturer in China if the government subsidizes the purchase of all-electric vehicles. One must also remember that the Japanese were initially derided for manufacturing low quality electronics and vehicles, but now they are fierce competitors that are known for their manufacturing prowess across the globe. Just imagine if BYD is able to start generating valuable intellectual property related to its products in addition to its production processes. Could BYD become the new Sony or the new Toyota? It’s possible, and Buffett has essentially gotten this option value on BYD’s success for free.

Buffett and Munger believe that while the twentieth century was the American Century, the twenty-first will be the Chinese Century. Thus, the BYD investment should be viewed as Berkshire’s stepping stone into China. Those who deride Buffett for having a subpar record over the last decade should take note: if Buffett continues to make investments in companies like BYD, Berkshire will easily outperform the U.S. stock market for years to come. Disclosure: Please note that the author currently owns shares in Berkshire Hathaway (BRK.B). Sumit Shah www.sumitshah.com