Learn how to rebalance your portfolio, improve your investment positions and set yourself up for maximum profit gain, during a recession.
Let’s look at the 20 year historical view of the stock market — the Dow Jones Industrial Average, to be more specific. As you can see, this Global COVID Pandemic that we are going through right now, is the 3rd recession that we’ve had, in the last 20 years.
What’s really interesting to see, is that following every recession period, the stock market has eventually climbed back up and has gone on to hit all time record highs. This has been true since the beginning of the stock market — and since a recession occurs, on average, every 4–6 years, if you take a step back and look at the market from a holistic, long-term investor standpoint, every 4–6 years you’re presented with a great opportunity to capitalize on a market decline, to optimize your investment positions.
So in this article, I’m going to share my personal trading strategy that I utilize whenever a recession occurs, to re-balance my portfolio, improve my investment positions and set myself up for maximum profit gain, when we exit the decline period and enter the next phase of growth in the economy.
How to Recession Proof Your Trading Strategy
We’re going to be covering 3 main topics:
- The truths and facts about recessions — there are some key things you need to know about a declining period in the market that’ll form the foundation of our strategy.
- Next, we’ll dive into the core tactics of the strategy itself.
- Lastly, we’ll briefly discuss what securities I typically choose when employing this strategy.
6 Key Things to Know About Recessions
Starting off with the first topic — there are 6 key foundational things you need to know about recessions, in general.
1. RECESSION DEFINITION
First, let’s define what a recession is. In the US, the National Bureau of Economic Research is the entity that officially designates whether or not a bear market is a recession — and here is their definition of the event.
A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.
Regarding this current Global Pandemic period that we’re in — on June 8th 2020, this organization made this official declaration.
The unprecedented magnitude of the decline in employment and production, and its broad reach across the entire economy, warrants the designation of THIS episode as a recession, even if it turns out to be briefer than earlier contractions.
So any time we see a sharp drop in GDP, employment, production and sales for a period of more than a few months — that’s a good indication that a recession might have begun.
2. RECESSION FREQUENCY
The next thing you need to know about recessions, is that they happen every 4–6 years.
This is a historical chart of US recessions from a past Business Insider article — all of the grey vertical bars, indicate time periods where the US was in a technical definition of a recession. Of course, you might not have heard of all of these because some of them were shorter and not as notable as some of the major ones like the Dot.Com Bust of the early 2000s or the Great Financial Crisis of 2008–2009, but they all happened and were all classified as recessions.
3. STOCK MARKET PULL BACK
Now, during a recession, it’s typical to see a stock market pull back in the area of 35%-45%. Of course, it varies slightly by what index you’re tracking, but if you look at the 3 major US market indices — the Dow Jones, S&P 500, and the Nasdaq Composite — they’ve all behaved in a similar fashion.
Let’s look back to this chart and overlay the percentage declines we’ve had in the last 3 recessions.
If we average out the stock market declines for these periods broadly — then we can surmise that from the results of the most recent experiences, on average, a recession results in about a 43% decline. And yes, I know time periods, and duration of the recession were all different — but this is just a broad average for directional purposes.
4. RECESSION LENGTH
The next thing we need to know — is how long a recession lasts, on average. If we broadly average out the last 2 major recessions, the mean comes out to be about 2 years and 1 month. If you look across the past 150 years — that average is more like 22 months, according to the National Bureau of Economic Research.
5. RECESSION RECOVERY CURVE
After that, the next piece of information to know about recessions, is what the average recovery curve looks like.
Financial analysts usually talk about these 3 types of recovery curves: a“V” where the stock market rebounds almost immediately after hitting the lows of the period, a “U” where the recovery is more gradual and there is roughly an equivalent time spend in both the decline slope and the recovery slope, and an “L” where the recovery takes a significantly longer time than the initial decline period.
For context, the recession in the early 2000s was kind of a “U”, the financial crash of 2008 was more like a long “L” that lasted almost 5 years and this current global pandemic is looking like it might be a straight “V.”
6. GROWTH AFTER RECESSION
And lastly, we have to keep in mind that the growth period following a recession, usually results in a large multiple gain in the stock market — compared to the amount of decline. In the early 2000s, the Dow gained 94 percent after the recession and starting from 2009, we saw the longest bull market in history, of 11 years, where the Dow gained 351%, from it’s previous recession lows.
Alright, now let’s move on to the trading strategy that I employ during a recession period. But before I go any further — I want to make sure that I clearly state this caveat.
I’m not a professional financial advisor, or a series 6 broker or even a professor of economics. I’m just a regular retail investor that has found a strategy that works for me. Also the tactics that I employ in this strategy are advanced trading tactics that I definitely wouldn’t recommend if you are new to trading and investing. The methodology I employ is pretty risky — and if you don’t know exactly what you’re doing, you could end up losing a lot of money, very quickly. I’m sharing my thoughts and strategies with you guys to show you ONE perspective on how to trade in a recession — but it’s your responsibility to decide what financial decisions you want to make according to your own risk tolerance and situation.
So with that out of the way, as a beginning to the explanation of this strategy, I want to first define the benchmark that we are comparing against. The safest and most conservative thing to do in a time of recession is simply to do nothing and hold. As history has shown us, after every recession period, the stock market always recovers 100% of its losses and eventually goes on to hit new record highs. So if you have confidence that the future performance of the stock market will be consistent with the past, the most prudent thing to do would be to hold onto all of your assets and simply wait for the market to recover.
And as I mentioned before, if you don’t know what you are doing, then trading in the midst of a stock market crash is one of the quickest ways to lose all of your capital – so if you are new to trading and investing, I’d highly recommend you take the safer approach of holding onto your assets and waiting out the recession. But, if you have some market experience and would like to see if you can use the recession as an opportunity to do better than this benchmark method of holding, then keep reading below.
So moving on, let’s define the objective of this trading strategy.
In a recession, almost everyone loses money. And since no one can predict the exact point in time, in which a recession will begin, nor can anyone predict the bottom of a recession period, any person or strategy claiming that they can time the market, is pretty much fraud — and that’s not what this strategy is based on.
The objective of this strategy is to sell as close to the beginning point of the decline as possible, and simply buy back into the market at a lower point than where you’ve sold, putting you in a good position to ride into the market recovery.
It sounds very simple and maybe even insubstantial — but let me show you the depth of the strategy — as I walk you guys through the execution.
Step 1: Always have a trailing stop set for your holdings at an 11% decline.
The first step in the strategy is to exit as close to the start of the market decline as possible. Remember when we discussed that a recession typically causes a 35%-45% decline in the stock market? What you want to do is exit at a point where there is definitely confirmation of a sharp decline in the market, thereby signally the potential start of a recession period, but is early enough to where you haven’t yet hit a 30%-40% drop in the market.
Now, some of you guys might ask, “But why 11%? Why not 8% or 13%? Why 11?”
Well, a couple reasons — first, a typical down day in the market can range anywhere between a 3%-5% daily drop, so if you set it too low, then you might get stopped out too early. But if you have a trailing stop set for 11%, then that means you’d have to have at least 3 consecutive days or 3 closely spaced down days in a short period of time to hit that trigger — and if that happens then that’s definitely out of the norm and cause for some concern.
Remember, you want to get as close to a solid confirmation of the beginning of a recession period as possible — and an 11% drop is enough confirmation to do that without the risk of a premature exit.
So let’s take our current recession as an example here of how this would instantiate. I’m going to be using just the Dow Jones Industrial Average within our examples — but we’ll get to actual equities you’ll want to invest in, later on.
Let’s say my total investments equaled $50,000 at the peak of the DOW on February 12, 2020, at 29,551 points. So a trailing stop of 11% would have hit on February 27, 2020 — as the Dow crossed below 26,300, to hit a low of 25,752 for the day.
Step 2: Recover your lost 11% by utilizing a triple-leveraged inverse ETF.
Now, if that initial 11% decline is an accurate signal of the start of a recession period — then we know from historical performance that the stock market has another probable 20%-25% drop to go, before it reaches the bottom.
So what we want to do here, is take advantage of a triple leveraged inverse ETF, to recover the initial trailing stop loss of 11%, and bring us back to our whole position. If you’re not familiar with leveraged or inverse ETFs, make sure you check out my previous article here, to get a full understanding of these advanced investment vehicles before you engage in this step.
So, as you guys know, in order to recover the principle amount of an initial loss with a triple leveraged inverse ETF — you only need to re-invest a 1/3 of the original principle value. In the case of our example, our original investment was $50,000, so if we invest only a third of that ($16,667) in a triple leveraged inverse ETF, if the market drops another 11%, we would recover the full $5500 that we’ve lost.
So we’d buy into a triple leveraged inverse ETF and set a limit sell at 22,919. In our current recession period, that order would have executed on March 12th, when the Dow opened at 22,184.
Effectively, what we’ve done here, is retained our initial investment value but moved our potential market position down to match the decline in the market.
Step 3: Determine the re-entry point
Now, once we’re in this position, we need to evaluate how far the market has come down holistically and determine how much more we think the market has to go, before we see a bottom.
Remember back when we discussed that a typical market decline in a recession results in a 35%-45% drop? At this point, we’ve seen the market contract about 22% — so we may only see about 10% more in decline before we see the recession floor.
But since none of us can predict what that low period would be — at this point of the strategy, we’re going to set a limit buy at 5% lower than the current market price. So that would be a 21,074 point position in the Dow, for our example.
So why 5%? Because a 5% drop from here represents a total 27% drop in the market from the peak.
The key here — is that you want to make sure you enter the market at this point, and not miss out, in case we’ve already hit the low and there is a rebound that happens next. So if the market typically drops 35%-45% in a recession, setting a re-entry point at a 27% drop — is a safe way to guarantee that you get into a position before the market rebounds. At this point, it’s better to get in quickly, rather than trying to time the market bottom and risk missing out and start chasing a market run-up.
So, going back to our example, with this step, we would have entered in our position here: on March 16th, when the DOW opened at 20,917.
Now, just a side note here — if you wanted, you could enter in just a 1/2 position here and wait to see if the market goes up or down and invest the remaining half then. But just remember that if it does goes up, you’d be dollar cost averaging into a higher position than if you had just entered into a full position at the 27% decline point.
Step 4: Ride the recovery curve
Now… we wait. At this stage, you’re fully invested back into the market and it’s just a waiting game for the market to recover and for you to see the extra gains in your portfolio. Let’s play out the rest of the market action up to this point.
The Dow continues lower until March 23rd — when it touches the lowest point at 18,213. Then by March 25th, the Dow climbs back up to the levels in which we re-entered the market in step 3.
And from that point on — in the case of our current recession, as of June 15th, the stock market is showing a seemingly “V” shaped recover, with the Dow rising 22% from it’s bottom, in just 3 months.
Now, this works out great for this current example in 2020, but you might be wondering, how would it have done if we applied this strategy to other recessions, like the financial crash of 2008.
Well — let’s take a look together.
On October 9th 2007 — the Dow Jones hits an all time high of 14,164.
Step 1: An 11% trailing stop order executes on January 8th as the Dow crosses below 12,605.
Step 2: Triple leveraged inverse ETF is bought and held until the sell order executes on July 1st 2008, as the Dow crosses below 11,219.
Step 3: Re-entry into the market at a full position happens on September 17, 2008 as the Dow crosses below 10,658.
Step 4: In this particular example — it’s a test of patience, because as we looked earlier, the financial crash of 2008 was a much longer “L” shaped recovery that took nearly 5 years for the Dow to climb back up to the levels that we were at previously.
But, if you had this patience and followed the guidelines of the strategy, then on February 28th of 2013 — when the market reached back up to the previous high, back in October 9th, your gain would have been 32% from your re-entry point back in September 17 of 2008.
At step 4 — it’s really just a waiting game, and again, this strategy is designed to put you in a better position to profit from the recession, in the long run. Also remember that our benchmark is doing nothing and holding through the recession. At this point, if you had kept that benchmark strategy, your investments would be back to even — at the point before the recession occurred, as opposed to being 32% positive.
But I will be honest — the longer a recession goes, the harder it is to keep steady on step 4. But in the long run, following a set strategy is always a better option than trying to play the market by gut feeling.
(By the way, if you would like to see this explanation visualized, click here to go to my video.)
Lastly — what are the different securities you should invest in as we employ this recession profiting strategy?
For the leveraged inverse ETFs, these are a few of the ones I’ve employed in my personal trading orders.
I try to stay with market index ETFs as much as possible as opposed to a particular niche or sector ETF — because I want to make sure I ride the wave of the entire market, either up or down.
In terms of what I would invest in on the re-entry, I typically re-balance my portfolio with a mix of 35% Index Mutual Funds, 45% stocks, and 20% ETFs. Here is what I’m currently holding at the moment.
In a separate article, I can go over why I choose certain stocks and what my holding strategy is — but for now, we’ll move on since this article is already turning out to be longer than I planned.
So — I hope this has helped provide one perspective on how you can trade during a recession period.
And remember — this is just one retail trader’s personal strategy — so make sure you take all of this with a grain of salt and make your financial and investment decisions on your own, based on your individual risk tolerance and situation.
**** Disclaimer *****
The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.