Investment portfolio strategy in times of recession

Economic cycles include periods of growth and decline, the latter generally being the most worrying for investors. Fortunately, there are strategies available to limit portfolio losses and even save gains during a recession.

Key points to remember

  • A recession is two consecutive quarters of negative economic growth, but there are investment strategies to protect yourself and profit from a downturn.
  • During recessions, investors tend to sell riskier holdings and turn to safer securities, such as government debt.
  • Investing in stocks is about owning high quality companies with a long history, as these companies tend to be more resistant to recessions.
  • Diversification is important, which includes fixed income products, consumer staples and low risk investments.

What is a recession?

A recession is a prolonged period of significant decline in economic activity. Typically, economists characterize two consecutive quarters of negative gross domestic product (GDP) growth as a recession, but other definitions exist.GDP is a measure of all the goods and services produced in a country during a given period.

Recessions are characterized by faltering consumer and business confidence, weakening employment, falling real incomes, and weakening sales and production, which is not exactly the case. environment that would lead to a rise in stock prices or a sunny outlook on stocks.

As far as the market is concerned, recessions tend to lead to increased risk aversion on the part of investors and subsequent flight to safety.On the bright side, however, recessions sooner or later give way to recoveries.

How an investment strategy works during a recession

The key to investing in a recession, whether before, during or after, is to keep an eye on the big picture, rather than trying to enter and exit various market sectors, niches and individual stocks. .

While there is historical evidence for the cyclical nature of some investments during recessions, the fact is that the timing of these cycles is beyond the reach of the retail investor. However, there is no need to be discouraged, as there are many ways that an ordinary person can invest to protect themselves and profit during such economic cycles.

Macroeconomics and Capital Markets

First, consider the macroeconomic aspects of a recession and how they affect capital markets. When a recession hits, businesses cut back on business investment, consumers slow down their spending, and people’s perceptions shift from optimism and expectation in pursuit of recent good times to pessimism and uncertainty about the future.

Naturally, during recessions, investors tend to be afraid, worry about the potential returns on investments and reduce the risks in their portfolios. These psychological factors are manifested in some major trends in the capital market.

Trends in the financial market recession

In equity markets, investors’ perceptions of increased risk often lead them to demand higher potential rates of return to own stocks. For expected returns to rise, current prices must fall, which happens when investors sell riskier holdings and turn to safer securities, such as government debt. This is why stock markets tend to fall, often precipitously, before recessions, as investors shift their investments.

History shows us that the stock markets have a strange ability to serve as a leading indicator of recessions. For example, markets began to decline sharply in the mid-2000s before the recession from March to November 2001.However, even on a downside, there is good news for investors, as pockets of relative outperformance can still be found in equity markets.

Stock selection during recessions

When investing in stocks during times of recession, the relatively safest places to invest are in high quality companies that have a long trading history, as these should be the companies that can handle prolonged periods of market weakness. .

For example, companies with strong balance sheets, including those with little debt and healthy cash flow, tend to do much better than companies with high operating leverage (debt) and low cash flow. . A business with a strong balance sheet and cash flow is better able to handle an economic downturn and more likely to fund operations despite tough economic times.

In contrast, a heavily indebted business can suffer damage if it cannot manage its debt payments and the costs associated with continuing to operate. While a company’s expenses are significant, an investor needs to ensure that they are not cutting costs in the wrong areas.

Historically, one of the safest places in the stock market is in consumer staples, which are products that consumers tend to buy regardless of economic conditions or their financial situation. Consumer staples include food, beverages, household items, alcohol, tobacco, and feminine hygiene products.These are usually the last products that a household withdraws from its budget.

In contrast, electronics retailers and other consumer discretionary businesses may suffer as consumers postpone high-end purchases.

Diversification always matters

That said, it’s dangerous to cram into just one industry, including consumer staples. Diversification is especially important in times of recession, when particular companies and sectors may be affected. Diversification across asset classes, such as fixed income and commodities, in addition to equities, can also help control portfolio losses.

Fixed income strategy

Bond markets are no exception to the general risk aversion of recessionary environments. Investors tend to avoid credit risks, such as corporate bonds (especially high yield bonds) and mortgage backed securities (MBS) because these investments have higher default rates than government securities.

As the economy weakens, businesses find it harder to generate income and profit, which can make it difficult to pay off debt and, in the worst case, lead to bankruptcy.

When investors sell these risky assets, they seek safety and look to US Treasury bonds. In other words, the prices of risky bonds fall as people sell, forcing the yields on those bonds to rise. Meanwhile, the prices of treasury bills are rising, which means their yields are falling.

Commodity investment

Another area of ​​investment to consider during a recession is commodities. Growing economies need inputs, especially natural resources. These needs increase with economic production, pushing up the prices of these resources.

Conversely, as economies slow down, demand slows down and commodity prices tend to fall. If investors think a recession is approaching, they will often sell commodities, which drives prices down. However, since commodities are traded on a global basis, a recession in the United States will not necessarily have a large direct impact on commodity prices.

Investing for the recovery

What about when the economy starts to recover? Just like in a downturn, in a recovery, you have to keep an eye on macroeconomic factors. One of the most common tools the government uses to reduce the impact of a recession is an accommodative monetary policy – lowering interest rates in order to increase the money supply, discouraging people from saving and encouraging savings. expenses. The overall objective is ultimately to increase economic activity.

One of the side effects of low interest rates is an increased demand for higher risk, higher yield investments. Therefore, the stock markets tend to perform very well in times of economic recovery. Some of the top performing stocks use operating leverage as part of their ongoing trading activities, especially since they often get beaten in times of downturn and become undervalued.

Leverage can also hurt during a recession, but it works well during good times, allowing businesses that take on debt to grow faster than businesses that don’t. Growth stocks and small cap stocks also tend to perform well during economic recoveries because investors accept risk.

Risk and return concerns

Likewise, in fixed income markets, increased demand for risk manifests itself in higher demand for credit risk, making corporate debt of all grades and mortgage-backed debt more attractive. : prices go up and yields go down. On the other hand, investors tend to move away from US Treasuries, pulling prices down while pushing up yields.

The same logic applies to commodity markets, which means that faster economic growth increases demand, which determines commodity prices. Remember, however, that commodities are traded globally: the US economy is not the only driver of demand for these resources.

The bottom line

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

Of course, you’re never going to time the start or end of a recession overnight, but anticipating a recession isn’t as hard as you might think. All that is needed is to have the discipline to ignore the crowds, steer clear of risky investments in times of extreme optimism, wait for the storm to come, and accept the risk when others are turning away from it.

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Don F. Davis

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