What are Good Investments in a Recession?
Whenever markets start to face some head winds, one of the most common questions to come thereafter becomes, “what to invest in during a recession?”. The easy answer is that there are no recession proof investments out there. The more realistic answer is that not all recessions are built the same way. Some recessions are due to pandemics, while others can be due to rising interest rates, a faulty housing dynamic, over extended stock markets, or a number of things.
Therefore, there is no magic bullet or recession proof investment. History rarely repeats itself, but it does lend itself to rhyming. So, looking at past recessions as our guide we will look at investments that have faired better than some of their counterparts and point out what different environments could benefit or detract from performance on that style of investment.
INVESTMENT GRADE BONDS
There is a great myth in investing that has been floating around for many years, which is when stocks sell off that bonds should do well and vice versa. This most recent bear market, which began in early 2022, has shown us the false nature of that statement as both bonds and stocks have had tumultuous years in terms of their returns so far.
The main reason behind bonds failing to be a safe haven in this environment has been, in large part, due to the fact that prevailing interest rates have moved substantially higher than where they were at the beginning of the year and are expected to do so even still. But let’s look at when bonds can be a good place to make money in a recession.
The Good
The typical rationale behind bonds doing the inverse of stocks in a downturn has to do with the concept of a “flight to safety”. When stocks are facing a recession and other troubles ahead, investors often find themselves asking where to park their money in the meantime so that it is safe, secure, and will pay them something to wait.
The reason that more traditional investment grade vanilla bonds are a good answer is twofold. One, because you don’t have to worry yourself as much with regards to the credit worthiness of the debtor of that bond, and because of that, the demand for that bond increases. And two, which is a direct result of one, is that the price of that bond now goes up since there is a higher demand for it. When a price goes up on a bond, the yield goes down (i.e. you buy a bond at 90 with a 5% coupon, it has a 5.55% yield). If that bonds price is driven up because of higher demand all the way to 100, the coupon hasn’t changed, but now the yield on that bond is 5% because the payout, or the coupon, is still the same.
The Bad
The reason why interest rate increases affect bonds so much goes back to the idea of an open marketplace. If the majority of a particular type of bond is giving out income to the tune of 2% and then along come other bonds that are now giving out income of 3%, then intuitively I am now going to have to offer my 2% bond out at a lower price to attract buyers if my intention is to sell that bond.
So, when the economy is in a state of increasing interest rates at an aggressive level like they were back in the 1970’s, or how they are doing so to some degree now, then the prices on bonds during those time periods drop substantially to the point that you may even feel just as much pain in the bond market as you would in the stock market.
This is why so often you will hear the term duration being utilized as something investors pay attention to as duration is a measure of the sensitivity of the price of a bond to a change in interest rates. It is important to note a bond’s duration, as it will often dictate the volatility that a particular bond will have as it relates to movements in interest rates, for better or for worse.
SECTOR SPECIFIC ALLOCATIONS
When looking back through the plethora of economic cycles that the market has gone through there tends to be certain sectors that perform better in particular parts of that cycle over others. The act of changing allocations to place your portfolio in the appropriate sectors based on what is going on in the economic cycle is known as a sector rotation strategy.
The Good
When the economy is heading into a recession, we can start to look at the different sectors that
exist and begin to think of what areas of the economy are more likely to remain in demand as it
compares to others. When looking at the stock market as a whole there are 11 different sectors that make up the entirety of it, provided in the diagram below.
Of the 11 sectors there are 3 that are typically referred to as defensive sectors. The three sectors in this group are healthcare, utilities, and consumer staples. Intuitively this makes sense as people who are hurt/ill will look to seek medical attention independent of whether we are in a recession or not. And the same line of logic extends to utilities, since people still need to keep the lights on, and consumer staples, since people rely on these companies for what are considered to be bare essentials for daily living.
When looking at years of past recessions there are times where you find companies in these sectors that not only survive a recession but thrive throughout it. Walmart is a great example of a consumer staples company that went through the 2008 financial crisis posting a positive return between the beginning and end of that bear market.
The Bad
While there are often individual companies that manage to generate positive performance in the worst of times, as a whole even defensive sectors tend to be dragged down during recessionary time periods. Broadly speaking these sectors, while performing better than their counterparts, will come down with the overall market just to a lesser degree.
The concept of rotating to the right sectors at the right time is generally a good one especially if you are able to accurately rotate at the appropriate time, but if all sectors are continually heading lower, it makes little to no sense to move your money from one sector to another if the end result is still, you losing money. Where real opportunities exist is determining the sectors that are best positioned to succeed coming out of the recessionary period, as that will often lead to attractive growth opportunities.
In the meantime during the midst of a recession it is often better to enact a strategy similar to our Recession Protocol™ which not only aims to limit the losses that come with a recession across most sectors, but also puts you in a position to deploy capital at an opportune time in the sectors positioned to succeed post-recession.
Financially Sound Companies
Whether it’s through looking at balance sheets, revenue growth, price relative to earnings, or a number of different metrics, there are many investors who look to determine which companies are better positioned relative to their counterparts to succeed in the environment that they face at a given time. This strategy is known as fundamental analysis.
The Good
The belief of fundamental analysis is rooted in the sense that because a company has a good set of “fundamentals” relative to where the stock is trading price wise at that given point and time; then it will be not only better suited to perform better to the upside, but that it will also hold up better than other stocks on the downside.
As mentioned before, there are multiple ways to enact fundamental analysis, and some of those investors who do so are some of the most respected investors of our time such as Warren Buffett, Peter Lynch, Benjamin Graham, etc. Typically, the fundamental analysis for these investors held true because they were confident in their analysis of the companies that they invested in. Therefore, they were able to stick to their ideas for the long term, or until they were convinced otherwise.
The Bad
The same issue with the sector rotation strategy exists with the fundamental analysis approach. Even though a fundamentally sound company may not go down as much as the rest of its competition, sometimes certain companies may go down even more, especially if whatever is causing the recession happens to impact that particular company more so than others. Yet, the cause of recession wasn’t baked into the analysis of the company to begin with. This highlights the biggest flaw within fundamental analysis in that it is overly reliant on past data.
What also holds true is that just because you evaluate a company based upon its fundamentals, it does not mean that the market will come to agree with you in the coming weeks, months, or even years. So often until there is a catalyst that changes the markets mind as it relates to that investment, you could be waiting for some time until you reap the rewards from it. Sometimes it is hard to determine whether you are buying a stock that is a deal, or if you are buying something that’s on sale for a reason.
Conclusion
The reality of it is that there are multiple ways to invest in a recession, and they each have their positives and negatives that will dictate which environments they thrive or fail in. The best way to sustain your posture throughout these time periods is being cognizant of the risk that each strategy comes with. From there you can form a portfolio that gives you the risk/reward profile that you are looking to have during the turbulent markets that come hand in hand with recessions.
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IMPORTANT DISCLOSURE INFORMATION
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