- All stocks will rise with a rising tide, therefore it’s wise to buy those stocks that won’t fall off a cliff in a recession.
- The usual suspects—like consumer staples, utilities, and healthcare—are good ideas, but not at any price.
- Bonds are close to becoming a win win situation.
Yesterday we analyzed the FED’s latest meeting minutes, and saw how when the FED applies historical probability calculations to their own estimations, the result is that anything can happen.
The FED itself stated that, in the next few years, economic growth could be anywhere between -0.5% and 4%, unemployment between 2% and 7%, and inflation between 1% and 3% with a 70% confidence interval. A 70% confidence interval means that there is a 30% chance economic indicators end up outside the above mentioned ranges.
If the FED states that there is a possibility for a recession and 7% unemployment, or 4% economic growth and 3% unemployment by 2019, I want to be prepared for all possible outcomes.
To make things easier to describe I’ll use two scenarios, one where economic growth goes below zero and one where it reaches 4%. Personally, I have a tendency to think the below zero scenario is much more likely than the 4% scenario, but for the sake of the exercise, we’ll use to both.
Stocks With 4% Growth
This is easy. If the real economy somehow reaches growth rates of around 4%, the rising tide will lift all boats. This is good to know because it doesn’t really matter what you own as everything will do well due to high levels of demand which will increase earnings.
A rising tide, alongside low interest rates, is exactly what has pushed stocks to the current highs.
Figure 1: With the economy expanding, it’s easy to invest. Source: FRED.
The above means that you don’t have to be invested in everything to achieve satisfying results which helps to protect your portfolio from the downside as the tide will eventually shift.
Stocks Going Into A Recession
In a recession, the first things that get hit are stocks. There’s no avoiding that. But if you own stocks whose earnings will remain stable even in a recession, your losses should be smaller than the market’s.
Good sectors to think about are healthcare, utilities, some real estate, consumer staples, and some commodities, think agricultural commodities. However, the point is not to jump straight into such stocks as many of the companies in these sectors tend to be extremely expensive. Paying a high price for a stock now won’t give any kind of protection in case of a recession. The secret is to look at defensive sectors stock by stock, analyze their earnings performance during the 2009 crisis, and invest in the companies that aren’t expensive in relation to their long-term earnings. You can use the CAPE ratio to look for such stocks.
The “free lunch” offered by defensive stocks is that if the economy does well, such stocks will rise, while if there is a bear market or a recession, such stock will give some level of protection. The level of protection is related to the initial price paid, the lower the better.
Another factor that can be a negative for stocks in both of the above scenarios is debt. Companies loaded with debt will have a difficult time if the economy booms because the FED will raise interest rates while in a recession, the burden of interest payments in combination with declining revenues might be impossible to weather.
To conclude on stocks, given their high current prices, it’s practically impossible not to experience losses if a bear market comes around, no matter the stocks owned. Therefore, you should only include in your portfolio those stocks where you’re happy with their long-term outlook as the earnings yield will determine the investment returns.
With improved economics, the FED will continue with interest rate hikes and with lowering its balance sheet. This should weigh on the required yields investors expect from bonds and lower their values.
However, with increasing interest rates, bond yields should also increase and become more attractive. Therefore, if you’re happy with the yield and are happy to hold the bond up to maturity, it should be a relatively safe investment. Additional protection can be achieved by buying Treasury Inflation-Protected Securities to protect your income from eventual inflation.
If there is a recession, bonds will become attractive again because the FED will be lowering interest rates. So, when you are happy with the yield and happy to hold a bond to maturity, it’s a good time to start thinking about bonds. If yields decline, you’ll end up with nice capital gains, which is a win-win situation.
If the economy grows at 4% with low inflation, gold will do extremely poorly. But if inflation increases, gold should offer inflationary protection as it has in the past.
Figure 2: The correlation between money stock and gold is far from perfect, but highly indicative. Source: FRED.
Being Well Diversified
Being well diversified means owning a bit of everything described above. This means that average returns will be below stock returns in a bull market, but significantly higher in bear markets.
It all boils down to how greedy or risk averse you are. If you are greedy, then the only place to be is stocks as other assets usually provide boring returns. If you are risk averse and also looking for capital protection, then a bit of everything is the best way to go.
Additionally, with some smart trading, portfolio rebalancing, and opportunistic investments, the risk averse investor can further increase their returns for the same risk. Keep reading Investiv Daily for more insights into reaching double digit returns with less risk.
Disclosure: I am long stocks, most of which were bought below book value and with single digit P/E ratios for maximum protection. Sectors: emerging markets, fertilizers, healthcare, food, education. I am long gold through a gold miner.