Recession concerns from the media are growing more and more pronounced. According to the U.S. Bureau of Economic Analysis Q2 2022 Report, the GDP declined by 0.9%.
After two consecutive quarters of a declining GDP, we are officially in recession territory.
In this article, we will discuss how capital markets work, the relationship between inflation, recession, and asset prices, and strategies to preserve your capital like dollar-cost averaging and passive income.
how markets tend to price developments in advance, why people generally expect asset prices to crash during recessions, and some potential recession strategies for protecting your capital.
Markets tend to price developments in advance
The massive bull run in stock, real estate, commodity, and cryptocurrency markets between March 2020 and November 2021 may very well predict the pricing of future inflation in advance. High networth investors may have already preserved their capital from both inflation and recession much earlier than the average retail investor.
Additionally, with big money investors having multiplied their capital over the past few years, some may want to choose to sit on risk-free cash during a recession, even if we also see an inflationary environment.
A counter argument could be made that following inflation, the anticipated recession is getting priced right now. Since markets like to price things before they happen, it’s possible asset prices will find a bottom sooner rather than later. Once the recession sets in and monetary easing comes to the rescue, markets could be poised to rebound.
The likelihood of this argument depends on the possible length and breadth of the recession. The U.S. stock market had its biggest bull run in history from 2010 until 2022. This also marks the era when Bitcoin was born and climbed to as high as $69,000 per coin. From day one, Bitcoin has been consistently marketed as a “hedge against the U.S. Dollar.”
So could it be possible that it took the markets a whopping 12 years to price future inflation? As a comparison, capital markets have priced a recession for only eight months as of yet. Therefore, although stocks and cryptocurrencies may look quite cheap in the present landscape, many are still quite expensive compared to, for example, their 2018 prices.
Similar to how it took 12 years to price an extended inflationary environment, it could take years to price a recession.
How does a recession drive down asset prices?
A recession alone does not have the power to drive down asset prices, especially during periods of high inflation. When cash loses its purchasing power, asset prices tend to improve.
However, both industrial production and consumer demand typically drop during a recession due to widespread and extended declines in economic activity. A decline in economic activity can trigger vicious cycles of layoffs and austerity, which can further weaken consumer demand.
To add salt to injury, high inflation also dilutes the purchasing power of individuals, putting further pressure on consumer demand and industrial production.
All of these factors can put pressure on the demand for commodities and spoil the earning expectations for stock companies. When companies are expected to generate lower profits (revenues may still go up due to inflation), people tend to sell off their stocks since lower profits would most likely drop the book value of a company.
Now, what does all of this have to do with the cryptocurrency market? Well, the cryptocurrency market has been correlated to the U.S. stock markets ever since its inception, and the degree of correlation has never been higher since the March 2020 Covid-19 crash.
In other words, Bitcoin and other cryptocurrencies have only seen growth under an expansionary phase of the global economy. The chart below illustrates an almost identical price advance, albeit on different scales, for Bitcoin and the S&P 500 stock index over the last 10 years.
Bitcoin and S&P 500 price charts against the U.S. Dollar (on a weekly scale)
With its history of correlation, the cryptocurrency markets may follow along with the global market recession.
In addition, if Europe faces an energy shock this winter due to Russia’s possible restrictions on the natural gas flow to the continent, global industry production may temporarily collapse. This could lead to a black swan event for the global markets.
How Bitcoin and other cryptocurrencies would behave under such a circumstance is a mystery. But historically speaking, they have not responded well to global black swan events like the Covid-19 crash.
During uncertain times, including a recession, people tend to feel “safer” when they hold or switch to cash, even if their purchasing power may deteriorate in the meantime. This is because cash is almost always the most easily convertible asset, and the convertibility of other asset classes becomes riskier during uncertain times.
Mandatory consumption vs. leisure consumption
A critical distinction to consider when evaluating investment opportunities during a recession is whether the underlying use case of an asset involves a mandatory product or service.
Some very simple examples are consumer staples such as utility (electricity, gas, and water), and grocery stock companies. Such businesses are usually considered “counter-cyclical” or “recession-resistant” stocks.
Since consumers cannot easily cut back on their basic consumption, companies that produce and sell basic goods under cheaper, generic brands may perform better during a recession, compared to companies that produce or sell non-obligatory, leisure items and services.
Leisure consumption can include anything from luxury items to tourism, expensive cosmetics to technological goods, or any other product or service that exists outside of those needed for physical survival.
It’s important to note that under severely declining economic activity, these “recession-proof” stocks could still see price reductions. However, the magnitude of these declines could be less when compared to other, non-essential industry stocks.
Nasdaq stocks like Netflix, Meta, and Coinbase have already experienced much stronger corrections since the 2021 market top, compared to traditional stocks in the S&P 500 and Dow Jones Industrial Average indices.
Dow Jones Industrial Average, S&P 500, and Nasdaq 100 charts for the last two years
As you can see in the chart above, the correction in the technology-focused Nasdaq 100 index has been considerably deeper compared to the drops in Dow Jones and S&P 500.
This situation poses another problem for cryptocurrencies since crypto is also considered a technology asset. As long as the traditional finance system remains solvent and banks remain operative, cryptocurrency’s superior technology narrative may not receive much attention during a recession.
The million-dollar question for investors is this: have we truly realized all of the possibilities cryptocurrencies have to offer?
Dangers of timing the markets
Regardless of the economic conditions and outlook for different asset classes, it is always very risky to time the markets. Trying to find the absolute bottom price for an asset is typically no different than gambling: no one has been able to predict or identify market tops and bottoms with certainty.
To avoid timing the markets, one approach is to view any large market crash as an opportunity to buy assets that could have long-term potential (regardless of industry and asset class). This is called “dollar-cost averaging.”
Major historical support levels
Major historical supports are the ranges where the price had spent a lot of time in the past, or levels that marked cycle tops or bottoms.
To find price supports and resistances, consider using a charting tool to analyze price fluctuations. The distance between major support levels can vary greatly depending on the asset class.
Since cryptocurrencies have generally been the most speculative assets, they have had a lot of inefficiently traded areas in the past, both to the upside and to the downside. Due to this, cryptocurrencies can have maximum distances to the next support levels when compared to other asset classes.
Bear and bull traps
A crucial thing to note is that prices hardly ever bottom or top at exactly those support or resistance figures.
As an example, during the June 2022 market bottom, Bitcoin bottomed neither at the previous cycle’s $20,000 top nor at the $13,000 major monthly support. Instead, it bottomed at $17,600, the exact middle point of those two support levels, to trick the maximum possible number of traders out. This is called a “bear trap.” The opposite would be a “bull trap,” which happens at the end of an uptrend.
Bitcoin/U.S. Dollar weekly price chart with the bear trap at $17,600
Downtrends come with a lot of bear traps, so it’s important to consider the possibility of these illusions before choosing to buy or sell crypto.
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Passive income via staking rewards
Staking is a common method to get additional benefits from digital assets.
Staking is the process of delegating coins or tokens with the purpose to validate transactions. In return for staking assets, users receive staking rewards in the form of the network’s native token. Therefore, the more assets staked raises the likelihood of those assets being chosen to validate transactions, thus increasing the possibility of earning rewards.
To stake assets on a blockchain network, you need an intermediary like a cryptocurrency exchange. When you buy cryptocurrency on CEX.IO or deposit your crypto to your CEX.IO account, your coins or tokens start to earn staking rewards automatically.
CEX.IO Staking strives to offer competitive reward rates for cryptocurrency purchases and deposits. It specifically offers up to 23% estimated annual yield for assets like Kava, Avalanche, Polkadot, Kusama, and more.
Besides making cryptocurrency passive income, users can also invest in companies with low debt and healthy cash flows. This could include companies that do not operate in basic industries like utilities and consumer staples, as long as they maintain a strong balance sheet.
Since uncertainties remain over how markets will respond during periods of economic downturn, diversifying investment portfolios with different assets and asset classes is a common practice for weathering recessions.
Allocating the majority of capital to risk-free or low-risk assets like cash and government bonds has usually been the norm since risky assets have shown poor performance during uncertain times.
However, history does not always repeat itself.
Despite the usual dynamics of a recession, unexpected and extenuating circumstances could contrarily fuel the demand for cryptocurrencies.
The expectation for cryptocurrencies to underperform during a recession relies on the assumption that the traditional finance system will remain intact. However, we could see a rush of renewed interest in cryptocurrencies to protect capital, as alternative financial services (such as DeFi) invite more individuals to explore the crypto ecosystem.
Additionally, if mass layoffs occur, people could look for alternative ways to earn money on the internet, such as play-to-earn blockchain games, which could drive up the demand for metaverse cryptocurrencies, etc.
In short, economic downturns and crises have the potential to bring their own, unique opportunities.
During a recession, it is possible to minimize losses or, in some cases, even turn a profit.
Where markets tend to price developments in advance while accounting for the relationship between recession, inflation, and asset prices, it’s possible to glean a more commanding view of pending market trends.
When buying assets in line with an individualized portfolio allocation plan, following practices like dollar-cost averaging can help reduce average investment costs during periods of downturn or uncertainty.
While economic downturns often breed uncertainty, unique opportunities can also arise in the shifting sands of market forces. Therefore, it’s good practice to keep a close eye on developments that could drive up the demand in select corners of the market.