Like it or not, recessions are a part of the economic cycle. Besides the economy contracting, recessions can lead to corrections, market crashes and bear markets. But recessions can also create some of the best opportunities in the stock market. Effectively investing during a recession can result in smaller losses, leaving more capital to reinvest at lower prices. In this article we will outline the ways investors can navigate an economic downturn, and some of the best recession-proof investments.
- What is a recession?
- Why recessions can create the best investment opportunities
- Forecasting recessions
- Short term vs. long term investing
- 7 Things to invest in during a recession
- Diversification and risk management for recessions
What is a recession?
Before looking at recession-proof investments, it’s worth looking at exactly what a recession is. A technical recession is defined as two consecutive quarters of negative GDP growth. However, government departments that monitor the economy have a more complex system for defining a recession.
Beyond the definition, a recession simply means that the total amount of economic growth is falling. Some sectors may continue to grow, while others contract – but the overall level of activity falls during a recession. Recessions are caused by a decline in investment and spending. This can happen for several reasons. Consumers can become over indebted, company valuations can be too high, or available capital can run out. A black swan event or a major corporate bankruptcy can also trigger an economic downturn.
When economic indicators point to a recession, confidence falls and a cycle of falling investment and spending begins. At this point, central banks will often cut interest rates to encourage companies to continue investing. Eventually the decline slows, and investment picks up as confidence returns to the economy.
Why recessions can create the best investment opportunities
An economic downturn will typically lead to lower profits for many of the leading companies. For this reason, it only takes the expectation of a recession for a stock market crash or correction to occur. But, investing during a recession also has a positive side to it. Although investors fear these economic downturns, they can also create some of the best buying opportunities. The great recession in 2008 seemed to many investors like the end of the world. Yet it was the buying opportunity of a lifetime, ahead of a ten-year bull market.
For several reasons, recessions can create great buying opportunities for investors. High quality stocks generally trade at a premium. The only chance to buy them with any sort of margin of safety is by investing during a recession. The field of behavioral finance shows just how irrational investors can be. The mistakes they make increase during bear markets and when volatility increases. This also creates opportunities. The best companies also gain market share during recessions when their competitors are cash strapped.
As far as investing during a recession goes, rather than after one goes, there are several ways to make money. Short selling is one approach and owning recession-proof investments is another. At the very least this can give you more buying power when a correction ends.
Forecasting recessions is not easy and the experts often get it wrong. They typically forecast recessions that don’t happen, and they often miss those that do. More important than trying to forecast recessions is being aware that no forecast is perfect. Nevertheless, there are few recession warnings signs that are worth watching. The most common is the inverted yield curve. This occurs when 10-year interest rates fall below 2-year rates and shows that there is a shortage of short-term liquidity. This occurred a few times in 2019.
Various indexes of the confidence of businesses, investors and consumers can also be tracked. If more than one of these indexes is at historically low levels, the probability of a recession is high. Other important indices are the purchasing managers index, new car sales and housing starts. Of course, rising unemployment is another potential signal. No single indicator can be used to predict a recession. But if most of these metrics are looking weak, it may be time to start looking for recession-proof investments.
Short term vs. long term investing
Investing during a recession should be approached from both a long term and short-term perspective. Over the long term, your portfolio must be able to weather unexpected recessions and volatility. This is achieved through strategic asset allocation, which we will come back to later.
In the short term, when the probability of a recession is high, you will be looking to move part of your portfolio into recession-proof investments. This is tactical asset allocation. But you also need to be aware that things may not go according to plan. There is always a chance that the expected recession doesn’t materialize. And, even when one does, your defensive assets may not perform as expected.
Tactical trades that don’t work out can end up damaging long term performance. Capital preservation is key, but you can also miss out on returns by being in the wrong assets during a bull market. The following are some of the ways you can mitigate this risk:
- Don’t attempt to move your entire portfolio into defensive assets.
- Avoid chasing defensive assets when their prices are already high.
- Have a clearly defined exit plan so you know when to move back into riskier assets.
7 Things to invest in during a recession
Defensive sectors are those that make similar profits throughout the economic cycle. They provide the goods and services that people buy regardless of the state of the economy.
The consumer staples sector is the largest defensive sector. It includes companies like Procter & Gamble that make hygiene products, detergents and other household products.
Healthcare companies are like an extension of the consumer staples sector. Insurers, healthcare providers and pharmaceutical companies are all companies that have little exposure to economic cycles.
Utilities like electricity and gas companies are also effective recession-proof investments. These companies have healthy margins and strong cash flows to start with. Often their prices are regulated and allow for stable profits. Furthermore, governments will not let them fail.
Defense companies are defensive as their contracts are not related to the economy, but to long term defense policies. In fact, defense spending may be increased during a recession to stimulate the economy.
A stock is not a good investment just because a stock is in a defensive sector. It must still have healthy margins and strong cash flows. Valuations also still matter, and any stock trading at historically high valuations should be avoided during a recession – even if it is in a defensive sector. In general, ETF investing is a good way to build a long-term portfolio. There are several defensive ETFs available – though they should be used with caution. These ETFs often end up with over-owned stocks which underperform regardless of the outcome.
Stocks with decent dividend yields and high dividend cover ratios can be very effective recession-proof investments. For a start, companies that pay dividends are cash flush which means risk is lower. Secondly, investors seek out the best return they can get during recessions. A passive income in form of a dividend yield of 2 or 3% is better than a growth stock with a falling share price.
The result is that high quality dividend stocks can perform quite well during recessions. But an attractive dividend yield must always be backed up by sustainable, positive cash flows. The higher the dividend cover ratio the better, as there is less chance of the dividend being cut.
Value stocks are regarded as recession-proof investments simply because they have limited downside. Momentum and growth stocks are priced for growth, while value stocks are priced closer to their intrinsic value.
While value stocks make sense when investing during a recession, you should still be selective. One of the biggest investing myths is that you should buy stocks with a low PE. Just because a stock appears cheap, does not make it a good investment. Shares should be assessed using a variety of stock valuation metrics to decide whether they are.
There are some compelling arguments for following an ESG investing strategy during a recession. A growing body of evidence suggests environmental, social and governance factors affect the long-term value of a company. ESG investing is rapidly becoming a viable compliment to factor investing.
Evidence suggests that management teams that take ESG issues seriously remove risk from their companies. Since investing during a recession entails moving to assets with lower risk, these companies tend to outperform. Thus, stocks with high ESG scores may prove to be more recession-proof investments.
ETFs with short exposure
Short selling individual stocks can be very profitable, but it is also quite risky. The most shorted stocks are often vulnerable to bear market rallies. A more prudent option is short exposure to the indexes likely to fall the most. The Nasdaq 100 index includes many of the growth stocks trading on the highest multiples. These are the stocks that are most vulnerable to a recession.
The ProShares Short QQQ ETF (PSQ) is an unleveraged inverse ETF on the Nasdaq index. This means its value goes up when the index falls. This is an effective way to gain short exposure to growth stocks and hedge a portfolio.
Treasury bonds are a traditional safe haven asset and will often outperform early on during a recession. They carry the highest credit rating and benefit when central banks cut rates. In the current low yield environment, they should be treated with caution though. With low yields, the upside for bonds is limited. They can also lose value quickly if or when the equity market recovers.
Finally, you should always have some cash in savings accounts. There are several reasons for this. Cash will still generate a small return as compound interest accumulates. It will also lower the volatility of your portfolio, giving you peace of mind and preventing irrational decision making. Most importantly, having cash available will allow you to pick up bargains when the correction slows.
Diversification and risk management for recessions
The assets mentioned above are typically the most effective recession-proof investments to consider when a recession is likely or under way. But, as mentioned, things don’t always go according to plan. For this reason, a portfolio should also be permanently structured to withstand unexpected recessions too. This is achieved by including portfolio hedging assets alongside riskier assets. Diversification that includes the following assets reduces volatility and protects the portfolio from crashes and recessions.
Hedge funds are one of the most effective portfolio hedges during recessions and bear markets. They can generate returns during bull markets, but also use short selling to capture downside moves and remove market risk. Modern funds leverage quantitative investing strategies and technology can make market timing work by reacting in real time. For example, Catana Capital’s Data Intelligence Fund uses artificial intelligence to exploit big data measuring market sentiment in real time.
Real estate is less liquid than listed instruments like stocks. This means real estate valuation are less volatile. While unlisted real estate is less volatile, it isn’t necessarily less risky in the longer term. If your risk tolerance is low, you should be cautious with this sector. It’s important to note that listed real estate investments like REITs are very different. Listed real estate is more correlated to interest rates and can come under pressure if rates rise.
Private equity and venture capital
Like real estate, private equity and venture capital funds are less liquid than listed instruments. The value of private investments is related to a company’s long-term prospects rather than market forces. So, they are still vulnerable to a recession, but not to the same extent as stocks.
Gold and silver are real assets with limited supply. Their values are not related to long term cash flows like financial assets and are more stable. Precious metals are regarded as safe haven assets and their value often appreciates when stock prices fall. More importantly though, they reduce portfolio volatility over the long term.
Conclusion: Investing during a recession
Investing during a recession can be stressful without a plan. But, investing during a recession can be a lot easier and even profitable with a well-diversified portfolio and a few tactical changes. A few recession-proof investments can limit the downside. However, you should also be looking for long term opportunities during a financial crisis because they don’t come along that often.