If you have paid any attention to financial news lately, you have probably heard increasing sentiment that the U.S. is headed into a recession. What does this mean? What causes recession? How should you invest in response?

Let’s discuss those questions.

Recessions 101

What is a recession? A recession is defined as a decline in gross domestic product (GDP) for two consecutive quarters. GDP refers to the value of all the finished goods and services produced by a country over a specific time period.

In simple terms, recession means a decline in economic activity. It usually means lower profits for companies, which means lower stock prices. We typically refer to recession in relation to the entire economy, but it’s possible for some sectors to be in recession, while others are not. More on that below.

What causes a recession? When an economy becomes “overheated,” supplies often lag demand and prices soar. That means inflation rises. But at some point, high prices cause consumer spending to slow down. That slowdown in activity means consumers are spending less on goods and services, which is why GDP can decline.

The Federal Reserve will attempt to control inflation with interest rates. Increasing interest rates can dampen spending. The so-called “soft landing” that you may have heard is an attempt to curb inflation without throwing the economy into a recession. This is difficult to achieve in practice.

The Current Situation

At present, the inflation rate is very high, and the Federal Reserve is raising interest rates in response. Consumers are spending far more for goods and services than they were a year ago. This will impact their ability to spend money on other items.

For example, I recently calculated that the average family is spending about $3,000 a year more for fuel than they were a year ago. Those increased costs act like a stealth tax, reducing the discretionary income of consumers to spend on other items. That helps the energy sector, but hurts other sectors.

The surge of energy prices was a factor in the 2008-2009 recession, and I believe it will be the dominant factor in the recession that I expect is coming. However, if high energy prices push us into recession, it’s possible that the energy sector will continue to do well even as the rest of the economy contracts.

Certain sectors tend to do better during a recession than others. Those sectors historically are utilities, health care, and consumer staples. That doesn’t necessarily mean that those sectors will see gains during a recession. In 2008, the utilities sector lost 29%, health care lost 23%, and consumer staples lost 15%. Yet they all outperformed the S&P 500, which was down 37% for the year.

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You should maintain perspective when investing during a recession. No sector rose in 2008. Not even the energy sector rose, even though high energy prices helped contribute to the recession. That’s because energy prices crashed in the second half of 2008. Despite a great first half of 2008, the energy sector closed down 39% for the year.

Investors in the energy sector may do well to heed the lesson of 2008. Recession means a contraction in demand of goods and services, and that leads to a contraction in the demand for oil. There is an old saying that the cure for high prices is high prices. That’s because high prices lead to impacts that reduce demand and increase supply. That could happen again with oil prices if the economy does slip into recession.

What’s Next?

Looking further ahead, which sectors do best as the economy comes out of a recession? Unsurprisingly, it is primarily the sectors that did the worst during the recession. The technology sector was down 41% in 2008, but then was the top-performing sector in 2009 with a return of 51%.

The financial sector didn’t bounce back as quickly. The housing bust was a major factor, in fact it is often cited as “the” factor, responsible for the 2008 recession. Financials were the worst-performing sector in 2008 with a loss of 55%. Financials turned in a positive return in 2009, but they still underperformed the S&P 500 in 2009, 2010, and 2011.

What would I do right now as an investor? I think you need to keep plenty of cash on hand. There’s no good answer for how long these conditions might last. But given the sharp correction in the technology sector, it may make sense to start dollar-cost averaging any extra money into some of the bigger technology names, especially if we do slip into recession. They may still have some declines ahead of them, but if history is any indication, they will soar as soon as there is light at the end of the tunnel.

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