Building The Best Portfolio For The Upcoming Recession

May 25, 2017

Building The Best Portfolio For The Upcoming Recession

  • Stocks will be hit badly. Low price earnings and high book values can provide some safety.
  • Bonds look much better than last year.
  • Alternative investments can be a jack-pot for your portfolio.

Introduction

Yesterday we discussed how a recession is imminent, especially if the trending down credit growth turns negative.

The most important thing now for investors is to prepare for such an event. Today, we’re going to dig deeper into the recession-related investing risks as different asset classes will be affected differently.

Stocks

In a recession, stocks are usually hit very badly. Even if a recession lasts an average 11 months (1945-2017), investors panic as sell their holdings. Panic selling in a recession that usually comes after a bubble of some kind is created by the fear that there is more to lose. Analysts start plotting the last quarter’s declining earnings into the future, alongside recession-like price to earnings (P/E) ratios, and the future suddenly doesn’t look so bright anymore.

One of the main misconceptions in investing is that the current situation will continue on indefinitely. The majority of investors currently think the economy is going to grow indefinitely, interest rates and inflation are going to stay low, and any shock will be absorbed by the FED. As much as this seems true at the moment, the economy always has a surprise in store for us. Sooner or later, things will change as it’s economic nature. Equally, a recession can’t last forever because growth is also inherent in economic nature. Even still, investors can’t see beyond the prevailing trend.

The myopic market creates two scenarios, one of high risk and one of opportunity. The sophisticated investor should take advantage of market cycles and the myopic market. Let’s first discuss the risks.

The Risks For Stocks In The Next Few Years

A recession would first hit corporate earnings and, unfortunately, earnings are extremely sensitive to changes in economic activity.


Figure 1: S&P 500 earnings are extremely volatile and sensitive to economic activity. Source: Multpl.

In the last recession, S&P 500 earnings fell from a high of 99.37 points in June 2007 to a low of 7.86 points in March 2009, a 92% drop.

As you can see above, current earnings are still below their 2007 peak which means that there hasn’t been real earnings growth in the last 10 years. This isn’t today’s topic, but it’s a clear indication that corporate managements don’t hold shareholders’ interest as their first concern.

Back to earnings, in the 2001 recession, S&P 500 earnings fell from a high of 75.37 in September 2000 to 33.68 in March 2002, a 55% drop.

These earnings drops, alongside negative, recession-like sentiment, sent stocks down more than 50% in both cases.


Figure 2: A recession usually hits the S&P 500 very hard. Source: Yahoo Finance.

So, you know what to expect from the S&P 500. Should it be part of your portfolio? That’s up to you, but there is a high probability that a recession will hit the economy in the next 4 years and send the S&P 500 down more than 50%. Even if the S&P 500 continues to grow at 10% per year, and a recession doesn’t arrive until 2021, those invested in the S&P 500 at the moment would still end up with a negative return:

CURRENT S&P 500: 2,394 points 

S&P 500 in 2021 with 10% annual growth: 3,505 points

S&P 500 in 2022 after the recession: 1,752 points

And this is a really, really optimistic scenario. A more realistic scenario would see the economy enter into a recession in 2018, S&P 500 earnings fall by 50%, and stocks to fall accordingly.

In conclusion, don’t own anything related to the S&P 500. If you don’t feel like owning anything other than S&P 500 stocks, then a good idea is to wait in cash. When stocks eventually fall, you can start buying. This isn’t what many call timing the market, this is simple common sense. I find it really crazy to own stocks with a P/E ratio of 25.33 in an economy that is at its peak.

Another option is to approach stocks from a value perspective. By buying stocks that trade below their book value but have stable business perspectives, you can at least protect your returns in the long term. Emerging markets are full of such stocks.

Bonds – Looking Better

Last year, I warned investors to avoid bonds as the FED was clear in its intention to increase interest rates. You can read the article here. However, many things have changed since then. Interest rates have gone up and bond values have declined.


Figure 3: U.S. Treasury 10-year yield. Source: Bloomberg.

If you know you will need the money in 10 years and you don’t want to run any risk, a 10-year U.S. government bond offers you a 2.26% yield and some potential upside. If the economy enters into a recession, the FED is going to lower rates, or at least not increase them as fast as planned. This will push interest rates lower and bond values higher.

I must say that bonds look much more attractive than they did last year and they can be a good tool for appropriate portfolio management in relation to one’s needs.

Government bonds hold no risk if held to maturity. By investing in various maturities, you can have some cash at different points in time which will allow you to seize potential opportunities created by a stock market decline.

Forget about high-yield bonds as their yield is at historical lows. This doesn’t mean the risk is low, just that high-yield bonds are in a bubble. In case of a recession, all those stretched companies will have a hard time. If there is no recession, interest rates will go up and high-yield will be in trouble again.

REITs – Those Little, Highly Leveraged Real Estate Beasts

Many see real estate as a safe haven investment, and it probably was when the gold standard was still in place. However, real estate prices have been inflated by low interest rates, even more so than stocks.


Figure 4: REITs (U.S. Real estate ETF) are much riskier than the S&P 500, so stay away. Source: Nasdaq.

REITs might look like an investment in safe real estate, but they are far from that. What REITs are are highly-leveraged, yield-focused investments. In a recession, many tenants default or close down shops, REIT income sharply declines, and debt payments become an issue, all in addition to lower real estate prices.

The largest holding of the U.S Real Estate ETF is American Tower Corp. (NYSE: AMT) which has 80% of all its assets financed by debt. Even if a recession doesn’t come, higher interest rates are going to be very detrimental to such types of investments.

Where To Invest

With the exception of bonds, I‘ve been pretty negative up to this point in today’s article. Well, I have to be frank with you, we’re living in an asset inflated environment and therefore in the next crisis, there is a high probability that all assets decline as people rush for liquidity. Therefore, as I said with bonds, the best way to invest now is for the short term.

Short term opportunities include merger arbitrage. Merger arbitrage is currently an out-of-favor investment strategy and therefore offers good risk-reward investing opportunities. More about merger arbitrage here.

Other shorter term investments include stocks with potential positive catalysts coming up, but here we are already entering a highly-sophisticated area of knowing what the earnings of a certain stock will look like. This requires lots of research and doesn’t carry much less risk than the S&P 500, but the returns are much higher especially if you look at cheap emerging markets.

Talking about emerging markets, these markets are also a good idea for the long-term investor. Many emerging sectors won’t be affected by an eventual U.S. recession, so the high yields and earnings should continue to reward the investor in any environment.

If all hell breaks loose, then gold is a good option as with a relatively small part of your portfolio, you can hedge yourself against losses that will probably come from the overvalued assets described above.

If you want inflation protection, a good option are Treasury Inflation-Protected Securities, or TIPS. They are a bit expensive for my taste, but TIPS should make up a part of an all-weather portfolio. More about that here.

Conclusion

Portfolio allocation is a delicate issue as it’s extremely related to personal goals and risk profiles. However, what I see is that many are invested in the S&P 500 with the notion that they are well diversified, will get the best returns as stocks have performed extremely well in the past, and carry low risk because they own the best stocks in the world. Such a perspective can be correct in a twenty- to thirty-year time frame, but in this environment, it’s extremely risky.

I’m very skeptical that global central banks—which have brought about this asset inflation bubble by relentlessly printing money in the last 8 years—will be able to control things and keep the system stable. If inflation starts to rise, which should be inevitable given the $18 trillion pumped into the system, there will be no other option for central banks than to reverse their actions and tighten. In that case, most assets will be pulled down as higher interest rates work on asset values like gravity.

Every investor should really dedicate time to finding tools that are suitable for him or her. I hope to have provided some help by describing the risks and potential rewards to some of the most common portfolio asset classes.