Managing Your Portfolio During a Recession
A recession is defined as, “a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in the gross domestic product (GDP) for two successive quarters.” In plain English, that means that business drops, on the whole, for six straight months. People stop or reduce their spending on dining out, new furniture, cars, jewelry, and other so-called “discretionary” items. Meanwhile, businesses often cut capital expenditures like new machinery, new employees, or moving to larger facilities.
Fortunately, there are measures you can take to potentially reduce the long-term damage to your net worth during times of economic stress. Take the time to consider what you can do to protect yourself and your family.
Focus on Consumer Staple Stocks
No matter how bad things get, people are going to figure out how to eat, buy toilet paper, and heat their homes. When money is scarce, items and services such as these—known as “consumer staples” and “energy”—constantly churn out profits for the companies that manufacture and sell them. Corporations like Procter & Gamble, Clorox, and Colgate-Palmolive aren’t likely to sell less toothpaste, shaving cream, laundry detergent, and dish soap unless things get really, really bad. They are bastions of financial strength in times of economic downturn.
Likewise, “affordable luxuries,” such as Coca-Cola, PepsiCo, Hershey, and Kraft Heinz Co. aren’t likely to feel too bad of a squeeze compared to the broader markets. The average consumer is unlikely to give up their afternoon Coke or switch to an off-brand chocolate bar because they suffered a pay cut or temporary job loss. Products such as Folgers may even do better as people shy away from $4 lattes and cappuccinos, but want to stick to brand names they know and trust.
Some businesses, such as pawnshops and payday lending stores, are probably going to experience sharp increases in profits and business, so it’s even possible to make outsized gains if you have no ethical qualms about owning these sorts of enterprises. That’s a decision that you will have to make for yourself.
Look for Companies with High Sustainable Dividend Yields
Jeremy Siegel, a respected professor and author of Why Boring is Almost Always More Profitable, has shown in his research that dividends can lower the amount of time it takes you to regain losses in an investment. This is because reinvested dividends during crashes and market corrections purchase more cheap shares that will, in the future, generate far higher profits when the market rebounds.
Also, dividend stocks often cause a stock to fall far less than non-dividend paying equities because they become “yield supported.”
As an example, imagine you were watching GPE Consulting Group common stock (a fictional company) at $100 per share. The shares pay a $5 dividend, yielding 5% ($5 cash dividend divided by $100 per share price), while United States Treasuries are paying 4.65%. Prospects look decent—not exciting, but as good as one can expect. Now, imagine that there is another company, River Rock Chocolate and Ice Cream (another fictional company) with a $100 share price and roughly the same prospects as GPE—except there's no cash dividend.
Now, imagine the stock market crashes. Investors panic and order their 401k plans to dump the equity mutual funds, thereby forcing professional money managers to get rid of stocks. Both GPE Consulting Group and River Rock Chocolate and Ice Cream crash to $60 per share. GPE now has a dividend yield of 8.33% while River Rock continues its no-payout policy. If the mutual fund manager has to decide which stocks to sell and which to keep, which one do you think will be sold more often? If prospects for the firms are equal, the dividend-paying stock is more likely to remain in the portfolio, while the non-dividend paying stock gets cut.
International investors, wealthy individuals, and institutions are also likely to notice if the shares of a company trade at prices where the dividend yield grossly exceeds bond yields. If they believe that the payout is sustainable (the company will continue to make enough profit to pay, or “service,” its dividend), they are going to be inclined to invest. The result of this is that portfolios consisting of more cash-generating dividend stocks tend to have far less volatility and experience gentler falls than their counterparts.
This trend holds, even when the dividend is cut, as long as the stock price declines at a greater percentage than the dividend. Another benefit is that cash dividends signal to the broader market that the profits reported on the income statement are tangible. In times of financial crisis, the fact that one firm can prove it is making money by sending you cash in the mail is extremely valuable in the eyes of investors.
Prepare by Stashing Cash
In times of economic stress, liquidity is king. In other words, during a recession, you want a lot of cash, cash equivalents, or easy access to money. Having cash at your disposal makes it easier to weather any recession-related economic downturns, such as job loss, pay cuts, or a decline in customers.
Many of the best value investors in the world have routinely kept cash on their balance sheet to serve as “dry powder” for when markets fall. Although the greenbacks can serve as a drag on returns when the markets are exploding, they offer large benefits when stock prices begin to fall. You can reduce the drag of cash during economic good times by collecting at least a few percentage points of interest from a high-interest savings account or money market dividends. Handled properly, cash may even keep pace with inflation. Tax-free municipal bonds, though less liquid than storing cash outright, can also be a good choice for the right type of investor.
Reduce Your Debt
An important part of reducing your risk during a recession is lowering your fixed payments, such as any debt payments you may have. The people who are most prepared for a recession could suffer a job loss or a sudden, unexpected cash need, without approaching the brink of disaster. Monthly debt payments are a drag on your ability to do this. Also, if things get extraordinarily difficult but you expect they will return to normal shortly, someone with less debt has more borrowing capacity. It's never a good idea to rack up debt, but having the ability to put essentials like groceries on a credit card could be all you need to stay afloat during the toughest economic times.
As you look for loans to reduce or pay off completely, start with credit card debt. Low-cost, consolidated student loans and home mortgages are typically the least worrisome. There are always exceptions—you are probably in trouble if you make a $25,000 salary and have $90,000 in student loans (it’s still possible, so don’t despair!)—but these types of loans come with tax advantages and relatively low interest rates. You are more likely to get in trouble with mounting credit card debt or car loan balances. Not only are the interest costs to these types of loans potentially enormous, depending upon your credit rating, but they aren’t tax-deductible. That makes their true cost, relative to other forms of debt like student loans, substantially more expensive. There are great resources out there to help you pay down your debt to strengthen your balance sheet.
Find an Asset Balance You Can Stick With
Investing is all about rationality, but it can be difficult to remain rational when you're watching stock prices fall sharply. That's why average people, who might not fully understand what a stock is or why they own shares of an S&P 500 index fund, may benefit from reducing their volatility (the rate and severity of price fluctuations). That way, they will be less likely to act on fear or panic and dump equities when they are cheap.
This topic is known as asset allocation. In short, the practice involves spreading an investor’s money across a diverse range of asset classes (stocks, bonds, mutual funds, real estate, gold, commodities, international firms, fine art, etc.). The theory is based on the idea that not all markets are correlated—when one goes down, another might remain untouched or even increase. Thus, the investor is less likely to panic, dividends are reinvested, dollar cost averaging plans remain intact, and the wealth manager has protected the client from their psychological urge to “conquer” the market by acting on short-term trends.
We see examples of why it's important to stick to your asset allocation every time there's a stock market crash. People who panic and rethink their asset allocation will sell stocks in their 401k plans at dirt cheap prices because they don't want to “lose more money.” While that may make sense for a day trader speculating on the short-term direction of lower quality stocks, it doesn’t hold water for long-term investors that are buying blue chip companies, reinvesting their dividends, and continuing to work. These panicked investors are moving their money into money market funds at a time when rates are low (rates typically fall when the stock market crashes). In the low-interest money markets, they earn anemic returns while Wall Street (historically) recovers and regains momentum. These same investors might not have noticed a significant downturn if they had a more balanced portfolio, so they wouldn't have sold stock at low prices—ultimately growing their wealth more than panicked investors.
The worst thing that can happen to your portfolio during a recession is that you lose your ability to generate income and are forced to sell off assets to cover living expenses. There's nothing inherently wrong with selling assets, but you are selling at a time when the securities (stocks, bonds, etc.) you own are likely to be cheap. Who wants to sell their house in a down market? Yet, that is precisely what many people do. You must be careful about when you choose to rebalance your portfolio.
Consider Investing in Tangible Goods
If a recession happens to be accompanied by rising inflation—which is not a given—you might want to consider investing in some sort of tangible asset that is less vulnerable to a drop in the purchasing power of the dollar. Investors that have great credit, plenty of cash, and little debt, for instance, might consider investing in real estate. This value-based approach is the heart of the statement often made by Warren Buffett: “Be greedy when others are fearful and fearful when others are greedy.”
The only caution is that there is considerable historical evidence that suggests real, after-tax, inflation-adjusted wealth is far more difficult to generate in the commodity and real estate markets than by owning businesses and common stocks. Of course, there are always exceptions, but on a buy-and-hold basis, they might not be as attractive for the average investor that doesn’t want to closely follow macroeconomics and housing market factors. Still, real estate and similar investments could offset the damage to bonds and other fixed-income investments during inflationary times.
The 21st century has seen massive economic growth in China, India, and other countries outside the U.S. One implication for an investor’s portfolio is that there is going to be a lot of wealth creation outside of the borders of the United States. As a country, we find ourselves in the same position as Great Britain during the 19th Century—when J.P. Morgan’s father was running his banking operations from London and shipping capital over to our nascent republic, investing in our infrastructure and corporations with the hope of big profits and growing markets.
Although this is certainly going to present some challenges for the U.S. as it adjusts to the changes, there is money to be made by taking advantage of the new global economy. These are important components in a global portfolio because the adage that “when the U.S. sneezes, the world catches a cold,” might not be true in the future. International assets provide a nice buffer to add to recession-resistant portfolios, since they may not directly correlate with the financial realities back home. However, don't forget that the fundamental rules of stock markets still apply. It isn’t enough to buy a good stock, in a good industry, operating from a growing country because if you pay too much, you’re going to lose money. It’s that simple.
Look for Hidden Bull Markets During a Recession
Former hedge fund manager Jim Cramer is famous for saying “there’s always a bull market somewhere.” He’s right. No matter how bad the economy, no matter how terrible the job market, nor how high the cost of debt, there is always some pocket of the world where circumstances have converged profitably. If you don’t feel as if you possess the necessary skills, experience, temperament, and expertise to find them in the financial markets, you might consider creating them yourself. A recession, after all, just means the overall economy is shrinking—it doesn’t mean you can’t increase your income!
Some companies may experience falling share prices while earnings-per-share go through the roof. Those opportunities don’t come along every day, but when they do, you can be certain that you have a much higher chance of being rewarded handsomely five or 10 years down the road. For example, in a broad economic recession, you might notice that a rapidly expanding teen retailer has fallen to fire-sale prices. After a few years of reinvesting dividends, the value of each share will likely bounce back and could even see a massive increase. Why? A few quarters of recession isn’t likely to make teenagers spend less in the long-run on fashion-forward denim jeans or polo shirts. When was the last time you heard a teenager say, “I’m not going shopping at this store due to the recent contraction in the gross domestic product"?
The Bottom Line
Although the media makes a great deal of noise when a country is in, or thought to be approaching, a recession, it isn’t the end of the world. If you spend conservatively, search for alternate sources of income, keep cash on hand, and reduce your debt, you're going to be fine. Likewise, if you run your own business and focus on keeping costs low, maximizing your margins, and reducing spending in-line, you’re probably going to come out ahead of the game.
Those who have studied the time value of money know that it can decades to reach true financial independence. You are likely to encounter many recessions during that time, perhaps even a depression. Just like getting in shape, earning your education, or raising children, building your fortune and becoming wealthy is not easy—or quick. In fact, at times, it can be downright frustrating, painful, and exasperating—but, in the end, it’s worth it.