Recession 411 - What it is and How it Should Affect Your Investments

What is a Recession?

President Kennedy's saying that a rising tide causes all the ships in the harbor to rise holds just as true on Wall Street as it does on the dock. Back in 2000 and 2001, the world watched as companies with no earnings, insurmountable debt, and inept management skyrocketed to billion dollar-status literally overnight. Those days are over, and the tide, it seems, went out in a hurry. Today, we face a much different situation with the markets spooked by a credit crisis brought on as a result of Wall Street firms buying and underwriting sub-prime mortgages with little or no documentation and then bundling them with other high-grade assets into securities known as CDO's, or collateralized debt obligations. Banks and brokers are taking enormous charges against earnings, causing concerns about liquidity and profitability.

Now, investors are faced with a problem that many have never encountered before: recession. There was a rumor that markets used to go down, and last year proved that it could happen. In January, the Federal Reserve held an emergency meeting and cut interest rates in order to try to stimulate an economy that was headed for a brick wall at 100 miles per hour. The result was a short-term boost in the stock market, but it lasted only a few weeks.

The technical definition of a recession

Now, many economists fear that we are headed for - or are in - a recession. Just what is it? Recession is defined as a period of economic retraction; when the economy actually gets smaller. Generally, two months of decline in the Gross Domestic Product (GDP) or a sharp rise in the unemployment rate, are red flags that a country is approaching, or in the midst of, such an economic contraction.

The last large-scale recession in the United States was in the late 70's and early 80's. There have been several minor ones including, most recently, in 2001 for a brief period of time. Gasoline and energy prices reached levels that had never before been seen, and almost 11% of the nation was unemployed. The prime lending rate reached over 21% (compared to 8.5% today.) Understandably, the housing industry came to a virtual standstill; very few people could afford mortgages with interest rates at such astronomical heights.