Investment portfolio strategy in times of recession

Business cycles include periods of growth and decline, and while downturns don’t last as long as expansions on average, they can be particularly costly for investors. Since 1937, the S&P 500 has lost an average of 32% in declines associated with recessions. Fortunately, there are strategies to limit portfolio losses and even record gains during a recession.

Key points to remember

  • A recession is a significant, widespread and prolonged decline in economic activity.
  • Riskier assets like stocks and high-yield bonds tend to lose value during recessions, while gold and US Treasuries appreciate.
  • Stocks of large companies with abundant and regular cash flows and dividends tend to outperform economically sensitive stocks during downturns.
  • Investors cannot reliably predict a recession, but diversification and measured steps to control risk can help preserve capital and position portfolios to take advantage of a recovery.

What is a recession?

A recession is a large and widespread decline in economic activity that usually lasts more than a few months. It is often defined in the media as two consecutive quarters of negative gross domestic product (GDP) growth. GDP is a measure of all goods and services produced in a country.

Symptoms of the recession include a loss of consumer and business confidence, weakening employment, falling real incomes, and falling sales and production, which is not exactly the environment that tends to lead to investor confidence and rising stock prices. In fact, recessions increase investors’ risk aversion.

The National Bureau of Economic Research dates recessions from the peak of prior economic expansion to the trough of economic decline. According to this definition, recessions end at the very beginning of a recovery,

Can the stock market predict a recession?

Economist Paul Samuelson joked that the stock market predicted nine of the last five recessions. That was in 1966, and 50 years later, the stock market’s record as a signal of recession has remained comparable.

Bear markets associated with recessions tend to start and deepen before economic activity and last longer than other bear markets.

But of course, there’s no way of knowing before or in the middle of a stock decline how deep or lasting it may be. An inverted yield curve has always been the most reliable, though far from infallible, recession indicator.

Overreacting to any signal of recession could prove costly: economic expansions often last longer than expected and generate some of the biggest stock market gains towards the end.

How Asset Classes Move During a Recession

Recall that recessions are relatively rare but expose economies and portfolios to the possibility of rapid declines, leading to growing risk aversion among investors and businesses. As risk premia—the excess returns demanded by investors over risk-free assets—rise, the prices of risky assets fall accordingly. As expected, asset classes whose returns are less dependent on economic growth tend to outperform.

Gold and bonds, US government as well as higher quality corporates have historically held up better during recessions, while high yield bonds and commodities have traditionally suffered alongside equities.

Experienced investors know they are unlikely to predict a recession in time to flee risky assets to safe havens. A diversified portfolio has an excellent chance of recouping losses incurred during a recession in the subsequent recovery.

Stock picking during recessions

The safest stocks to hold during a recession are those of large, profitable and reliable companies with a long history of downturns and bear markets. Companies with strong balance sheets and healthy cash flows tend to fare better in a recession than those that are heavily indebted or face a sharp drop in demand for their products.

Historically, the consumer staples sector has outperformed during recessions because it provides products that consumers tend to buy regardless of economic conditions or their financial situation. Basic consumer goods include food, beverages, household goods, alcohol, tobacco and toiletries.

In contrast, appliance retailers, automakers and technology providers may suffer from reduced consumer and business spending.

Investing for recovery

Recessions are relatively rare events and countries have fiscal and monetary policy tools that support recovery. Once the imbalances that led to the recession are corrected, economies tend to rebound even in the absence of political support.

As a recovery takes hold, recessionary risk factors such as high operating leverage and reliance on economic momentum can turn into advantages for growth and small-cap stocks that may have been undervalued in the meantime.

In fixed income markets, the increased demand for risk is making corporate debt of all categories and mortgage-backed securities relatively more attractive. As the risk premium declines, the yield spreads of this debt relative to US Treasuries of similar maturity also decline. Government bonds tend to fall, pushing yields higher. This means that riskier debt could still lose value in absolute terms even if it outperforms Treasuries.

A return to growth also tends to be good news for commodities, as increased economic activity stimulates demand for commodities. Remember, however, that commodities are traded on a global basis – the US economy is not the only driver of demand for these resources.

The essential

When recessions hit, it’s best to focus on the long-term horizon and manage your exposures, limiting risk and setting aside capital to invest during the recovery.

While no investor can hope to reliably time the onset of a recession or should react by shunning risky assets entirely, careful diversification ahead of time can preserve capital and position you to take advantage of a rally.

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Don F. Davis