Understanding The Economy When Investing

“Risk comes from not knowing what you’re doing. “

Warren Buffett


A recession is never far from most investors’ minds. Understanding risks such as slowing growth when investing is essential. It is why I advocate that beginning investors have at least a cursory knowledge about the direction of the economy, inflation, and interest rates.

Learn how the Fed plays a meaningful role. Its actions may impact the financial markets. To arm me, I always sift through economic and financial data, accessing various sources daily. Daily, I read a lot of commentaries though not nearly as much as Warren Buffett does. He reportedly reads at least 500 pages of corporate reports per day.

Fears Of Recession Should Not Stop You From Investing

We had a long recovery from the dark days of the Great Recession. As such, the bull market had been a lengthy and profitable one for investors. That is until the effects of COVID caused an economic downturn in 2020 and into 2021.  

Nevertheless, it is not unusual to hear of the prospects of a recession. Signs of an economic downturn sometimes causes the markets to be turbulent as headline risk increases. Experienced investors look for recessionary signs to either endorse or dismiss. In any case, recessions cause declines in the stock market. Longer-term investors will ride through the market downturns.

While I am not a soothsayer, I certainly want you to be aware of these potential overhangs in the market. That doesn’t mean you need to make large-scale changes to your stock portfolio or risk allocations. As a long term investor now, I typically would not make any significant adjustments to my portfolio. Market volatility occurs regularly and sometimes provides more buying than selling opportunities. Those who trade stocks with a shorter horizon may feel differently.


4 Ways To Recognize A Potential Recession:


1. Mahalanobis Distance. What’s That?!

This concept is hard enough to pronounce, let alone to explain.  A recent study using Mahalanobis Distance by MIT Sloan School of Management and State Street Associates points to a 70% chance of a recession in the next 6 months. The researchers created an index based on four market factors–industrial production, nonfarm payrolls, stock market returns, and the yield curve slope.

They compared the current relationships of these metrics to historical numbers going back to 1916. When the index topped 70%, the likelihood of a recession in the next six months rose to 70%.

Mahalanobis Distance originated in the 1920s to analyze and classify human skulls, but it has relevance for economic contexts. There is controversy surrounding the accuracy of the Mahalanobis Distance. In contrast to this study, most economists aren’t forecasting an imminent slowdown. That said, there are a few other predictors that may signal a possible downturn.

This index proved to be a reliable recession indicator, pointing to the 2020 recession though it did not spot the pandemic as its cause.

2. Inverted Yield Curve

Typically, a standard yield curve reflects the length of maturities for a particular security, such as US Treasuries. A longer maturity will have higher yields for the added risk. Specifically, the ten year Treasury typically has a higher yield than the three month Treasury bill.

However, in 2019, an inverted yield emerged for a prolonged time, specifically from May to mid-October. The inverted yield curve–when the three-month T-bill yield was higher than the ten year Treasury security–signaling a recession and spooking the market. The inverted yield curve raised expectations of a recession between January and November 2020, which fit with the Mahalanobis Distance timeframe.

Inversion yields can appear for days in a row and then disappear without any significance. I will say that some smart folks I listen to pay close attention to this recession predictor.

3. Velocity of Money

Investors look at the velocity of money closely for signs of slowing consumer spending. The calculation of the velocity of money is a ratio of Gross Domestic Product (GDP) to a country’s money supply. As a measure of money supply,  M1 (includes cash and checking accounts) is most liquid while liquid M2 is less liquid. M2 has M1 along with savings deposits, time deposits, and money market securities.

High money velocity reflects an expanding economy. As a leading economic indicator, it points to rising consumer spending and rising stocks. On the other hand, when money velocity falls, people start to save money, and spending drops, and stocks decline in response.

4. The Coronavirus Overhang

There has been great angst surrounding the coronavirus since its outbreak in China in December 2019. As we now know, the pandemic quickly required unusual steps such as lockdowns and social distancing, causing a severe economic downturn. 

Before confirmation, fear of the virus creates turbulence in the stock market. The still present pandemic adds uncertainties, affecting certain individual stocks (e.g., airline, cruise, and travel stocks)  more than others. Virus outbreaks presume that people will avoid unnecessary traveling or dining out. Particular news such as business closures can derail stable economic trends or change market sentiment.

There have been many viruses, which are human tragedies for many. However, they have not been overly harmful to the stock market as seen in these charts. Still, investors learned this virus is more severe, causing still high unemployment. The optimism of effective vaccines is helping the market to outperform now.  

 7 Tips For Investors Learning About The Relationship Between The Economy And The Markets


1. Be Informed About The Business Cycles

Like any investor, I want to understand the general economic outlook and potential problems on the horizon like a recession, rising interest rates, and consumer spending.

For instance, when rates rise, it may mean higher inflation and consumer higher prices. Directionally, this translates into less consumer spending, impeding business growth and higher unemployment. Those indicators will point to declines in stocks. On the other hand, decreasing interest rates are favorable for consumers buying homes, cars, or making big purchases. Stocks tend to rise in that environment.

The economy moves through different economic cycles where other parts of the economy do better at various times.

Economic Indicators For Different Cycles

The Fed will look at many economic and inflation indicators leading, coincident or lagging metrics. A leading indicator occurs ahead of the business cycle when the economy expands. The S&P 500 index can be predictive of the economy. A coincident indicator tracks current economic activity (e.g. personal income), and lagging metrics (e.g., unemployment rate) usually after a shift occurs.

With different industries doing well at other times of the business cycle, diversification of your portfolio becomes an essential aspect of investing. Most investors can’t time when the cycle changes happen. However, holding a diverse group of stocks reflecting various industries can smooth out your risk.

Cyclical and housing companies benefit from early economic stages as consumer spending increases and rates decline, while defensive companies such as utilities and healthcare companies do well late in the cycle. Mutual funds provide diversification of stocks in the three stages.

2. Should You Sell Your Stocks During Downturns?

Does an economic downturn mean you should sell stocks? Not necessarily if you have a long term strategy. Financial markets go through corrections, bull and bear markets. Selling during economic downturns provides actual rather than unrealized losses. Many times that is the worse time to sell your securities. However, about one-third of Americans who were investing during one of the latest downturns sold part or all of their holdings. Learn how to handle market volatility in this article.

Using the NerdWallet Stock Market Crash calculator, let’s assume you have a stock portfolio of $100,000 before the market drop. At the trough of the Great Recession (2009), your portfolio will have fallen to $43,200, a 56.8% decline in less than two years. However, by December 31, 2018, if you hadn’t sold your stock, your holdings would have more than recovered to $160,200. Imagine if you had sold at the bottom of the market as many people did!

Don’t Panic And Sell When There Is Market Turbulence

When investing for the long term, it is better to weather the correction or volatility. To lessen your risks for economic pressures, make sure that your asset portfolio is diversified (as we discussed above). Different asset classes–stocks, bonds, money market/cash-equivalent securities– may act differently to market conditions. Use either the best performing actively managed mutual funds, higher fees, or low-cost passively managed mutual funds for stocks, bonds, and money markets.

Good investing leads to building wealth by using proper risk management and finding fundamentally well-positioned stocks at attractive valuations. If you are inclined to do your stock picking, there is a learning curve but it can be gratifying. 

Investors evaluate a company’s prospects and the estimates of its revenues, margins, and earnings to determine the fair value of the stock. A good investment is finding stocks below fair value, that is, at an attractive valuation.

3. Understand How To Reduce Risk

All investments involve risk. Find where your comfort zone when considering taking on your bet. Your risk tolerance and mix of assets may change at different life stages.

Typically, you want to be more conservative when you are considering retirement. Diversification is the best way to reduce your risk. Don’t put all of your savings into investments. Keep some of your cash portions into high yield savings accounts or money market securities that are easily accessible. Consider meeting with a financial advisor to review your plan.

Make sure you have liquidity readily available for economic downturns or unforeseen events. This is the primary purpose of having an emergency fund that can take care of your primary living needs for at least six months.

4. Add To Your Tax-Advantaged Retirement Accounts

Your retirement accounts are tax-advantaged, which are different than your taxable investment accounts. You can lessen your taxes for investment accounts by using a buy-hold strategy.  Holding stocks for at least one year and one day, investors pay taxes at the 20% capital gains rate. The capital gains rate is more tax-efficient than the ordinary tax rate for short-term trading.

While you may benefit from tax efficiencies, investment accounts are taxable, not tax-advantaged as retirement accounts. Dollars invested into your 401K account come from your pay-check, are tax-deferred, thus reducing your taxes for that year.

Automate Your Accounts

Remember to continue to add to retirement accounts regularly. Make sure there are regular withdrawals from your paycheck to your employer-sponsored 401K account. Increase your contribution when you get raises or bonuses so you can earn your company’s contributed match if offered. Automate your savings to go directly into these accounts from your paycheck.

Employer matching of your 401K contributions means the company may contribute 50 cents on the dollar up to 6% of your salary each year you contribute. The more you contribute up to the cap, the more you receive in the match. Make sure to contribute to your Roth IRA account to the max.

5. Investors Should Understand The Fed’s Role

Those interested in personal finance and investing, in particular, should have a working knowledge of what the Fed does. Its actions affect all aspects of money and investing.

The Fed influences our economy, our borrowing rates, our investments. They communicate with the public and add their voice of reason when threats to our financial system. They can also provide uncertainty to our financial markets through transparent communications.

The Fed Chair Jerome Powell swiftly reduced rates and pumped liquidity into the markets amidst a declining economy as the virus became a pandemic. The financial markets responded positively to this aggressive move. Stocks reacted swiftly, declining at the end of that year, erasing strong gains.

To learn more about what the Fed does, take a look at our post: 11 Reasons Why Investors Need To Understand The Fed.

6. Stock Market Games Can Teach You How To Invest

You should invest as early as possible, even if it is in small increments. I have taught investing to my college students using simulated stock market games. Getting familiar with the terminology and the basics without losing real money can be a good way to start. Simulated games provide lessons on the financial markets and the economy.

Stock market games are a great way to practice whether you are a beginning investor or investing for awhile. These games are an example of learning by doing, also known as experiential learning, and useful learning tools. Investing can be daunting for the experienced investor, let alone for those who are just starting out. Virtual games are free, fun, readily available, and user-friendly. They offer participants a faster learning curve to build investment skills and better financial habits.

Stock market games can help to teach you how to invest, as discussed in our article.

7. Knowing Investor Jargon Can Be Helpful

Investor language can be confusing. Those who have worked on idiosyncratic Wall Street recognize a different language and culture that permeates the business. Each area–research, sales, trading, investment banking, and money management— has its jargon that can be interchangeable. For those who want to work on Wall Street or simply want to know the basics of investing, this post, where we explain Wall Street jargon, is for you. Invest as early as possible. Use small increments of money at first just to get started.

Final Thoughts

Investing in stocks can be a risky business. However, returns on stocks can approach 10% based on the historical S& P 500 index. Owning stocks is the best way to accumulate wealth. 

Beginning investors those more experienced should know how the economy works along with the impact the Fed’s actions may have on financial markets. There are certain actions you can take to minimize your portfolio’s risks while realizing solid long term returns. The earlier you can save money for investing and for retirement, the better you will be positioned.

Thank you for reading! If you are an investor, how do you lessen your risks? We would love to hear from you!


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