- What has to be done in the late part of the economic cycle isn’t a secret. I’ll describe the how and what.
- However, as always in investing, the question is why we aren’t doing the rational thing.
- I’ll ask you a question that will help you answer how much and whether you should rebalance.
Yesterday, we discussed how the economy is in the late part of the economic cycle and everything is leading toward a recession.
No one knows exactly when the next recession will start or what the trigger will be. So the only thing to do is to be prepared.
In today’s article, I’ll discuss a few portfolio strategies that you can apply that relate to your investment horizons, investing style, and risk and hedging appetites.
Rebalance Your Equities Portfolio Toward:
As the economy starts showing the first cracks, investors’ instinct is always to run for safety. By investing in quality now, while the majority are still running after growth, you can stay ahead of what will happen and take advantage while lowering the risk of owning growth stocks so late in the cycle.
Look for companies with high margins, strong secular trends, stable cash flows, and strong business moats that won’t be impacted by cyclicality. Sectors include consumer staples, pharmaceuticals, utilities, and healthcare in addition to all those companies that will continue to benefit from the current secular trends no matter what happens with the economy. Those secular trends include: strategic metals, global middle class and emerging markets growth, autonomous driving, continuation of the development in Asia, growth in India, etc.
Figure 1: Sectors that do well in the late part of the economic cycle. Source: Fidelity.
However, be careful not to overpay for such companies, a high valuation will lead to a negative return no matter the quality.
While increasing the exposure to defensive stocks, it’s wise to lower your exposure to negative secular trends where stocks are still relatively highly priced in the overvalued current market. Aging developed markets populations, huge government debt burdens, decline in productivity, and lack competitiveness are some of the secular trends to be aware of.
On top of sectors and trends, look at book values. In a recession, most companies aren’t profitable and therefore the only value left to protect the stock price is the tangible book value. By looking at price to book values, you can find companies that offer the same upside to the market but with much less downside due to a margin of safety. Also, highly leveraged companies should be avoided as in a tight liquidity scenario, those are the first to go into refinancing trouble.
Start Taking Advantage Of Higher Interest Rates – Bonds & Cash
As you rebalance the risky assets that have rewarded you extremely well in the last 8 years, you might want to take a look at bonds.
The one-year treasury offers 1.4%, which isn’t much but brings capital protection and gives quick access to liquidity if necessary, even shorter-term bonds should do fine. In case of lower interest rates due to new monetary easing policies, the rise in bond values could be an excellent hedge and protection.
Increase Or Initiate Exposure To Hedges
Hedges are investments that are supposed to do the opposite of what your core portfolio does. As we all know, central banks will lower interest rates below zero and print as much liquidity into the system, if necessary, to help restore the economy. Anything related to gold will be a great hedge, especially if we see rising inflation and a slowdown in economic growth.
The Problem? Actually Doing These Things
Now, we all know we are in the late part of the economic cycle, and we all know what we should do. The question is: why won’t we do it?
The answer is pretty simple: greed.
By investing properly, thus lowering your risks in the late stages of the economic cycle, you are inevitably lowering your potential returns if things continue to go as they have been going for the last 8 years.
Figure 2: Nvidia, Alibaba, and Wynn Resorts stock prices in the last year (up 176%, 65%, and 42%, respectively). Source: Nasdaq.
Returns like those shown in the figure above are a temptation that many can’t let go of. This is an excellent example of irrational investor behavior where investors completely forget about the risks and focus only on the rewards. The point is that the higher the price of something is, the higher the risk is.
The best exercise you can do to help you determine how much you should rebalance to the above mentioned defensive sectors is to ask yourself how you would handle your portfolio if a recession starts today.
Let’s say we start with an S&P 500 correction of 10% over the next month. That’s not so terrible and things still look good, so most people won’t rebalance as the tech stocks are just a little cheaper now.
Then the first quarter with negative economic growth comes in and the market drops another 10%, but it’s expected to recover as the negative economic growth is attributed to the last few hurricanes afflicting coastal areas.
The second quarter delivers even worse news, people start to panic, many companies are unable to refinance their debt, and we have finally a full-blown crisis that lowers the S&P 500 by another 30% points in a few months. After a year, the economy is in a recession, unemployment is over 7%, the FED is printing money, and inflation is rising which doesn’t allow for lower interest rates to push up the economy.
So how would you do in such an environment? Think on that and see if you need to rebalance anything.
Keep reading Investiv Daily as I’ll continue to discuss sectors and interesting strategies to lower your portfolio risk and increase your returns.