Sam Explains: While recessions cause fear, they are a necessary reset for the economy

The mere mention of the word recession is often enough to strike fear into the hearts of investors. While an economic downturn is never welcome, it serves as a reset for the economy, and if investors navigate one correctly, it might not be so frightful after all.

The word recession refers to a significant and far-reaching downturn in the economy. While recessions can cause layoffs and hardships for families, they are necessary to maintain a healthy economy from an investor’s point of view.

Recessions are a period of contraction in the economic cycle, with times of economic growth being the expansionary side of the cycle. As withinterest rates, being at one extreme for too long is damaging, meaning too much growth may eventually lead to complete economic collapse.

Contractionary periods keep markets in check, weed out unhealthy businesses and reset the price of misvalued assets.

There is a saying regarding stocks: they take the stairs up and the elevator down. While it often seems this way, it is easy to overlook a 60% gain to an asset over a few years but not a 30% drop in a day. If investors do not panic and sell during a recession, they will eventually profit more over time.

To back up this statement, let’s look at the history of markets and recessions in the U.S. from1871-2022, as the average real total return for U.S. stocks was 6.8%. During the same time, there were months such as April 1932, which returned minus 24%, and August 1932, which returned 50.3%.

Throughout U.S. history, the economy faced numerous recessions such as the one that began with the Panic of 1873 and lasted five years. However, if you invested $1,000 in 1871, your return today, adjusted for inflation, would equal $22,963,570.

Now consider the returns from 1932. If you sold when times looked bleak, you would have lost 24%, but if you sold when times were good, you would gain 50%. Recessions hurt investors when they panic, but if you stay cool and level-headed, you will earn a constant positive return of about 6.8% a year based on historical patterns.

Just as there is a saying about stairs and elevators, there is also a saying that weeds kill healthy grass.

Look at your yard. It all might look green and healthy, but in reality, weeds kill what is healthy. This concept also applies to the economy.

The U.S. confronted one of the largest recessions in history in the 1930s. However, this was also a decade of economic advancement that would not show its face until later years. Throughout the Great Depression, thousands of businesses failed, but the healthy ones weathered the storm and set themselves on track for even more success.

Take the railroads for example. While few people were utilizing their services during hard times, railroad companies took the opportunity to upgrade their locomotives and revamp their workforce. By the recession’s end, railroads could carry as many passengers as during the previous boom years but did it more efficiently and cheaper, creating more profit.

This kind of event is not unique to railroads and the 1930s. During a short recession in 1921, U.S. nominal output contracted by 24%, but the year following, manufacturing productivity jumped an astonishing 20%, providing fuel for the Roaring Twenties. These events create a pattern: recessions may act like weed killers and kill what is unhealthy, allowing the grass to grow and thrive.

Recessions also reset the economy and put right what has gone astray, usually asset prices. You have probably heard of the Dot-com bubble, but to show how wild the markets had become, let’s look at Cisco stock.

The stock rose 300% in 1999 to $60 per share, with a value of $600 billion and an implied growth rate that would make it larger than the entire U.S. economy in 20 years.

A reset eventually occurred, with the bubble bursting and the stock falling around 80%. A similar thing happened around 2008 when the housing market crashed. People were loaned money with no way of repaying, resulting in defaults and foreclosures.

This time also saw the fall of companies like Lehman Brothers. But without a reset, more cases like Cisco and 2008 would have occurred, with more severe repercussions.

People fear recessions because they do not understand how necessary they are to maintain a healthy economy. Without periods of contraction, markets would run wild, and complete economic collapse would be imminent.