The topic of a recession has weighed heavily on the minds of the American public and the American investor for quite a while now – and for good reason.
Although we can find a sliver of good news here and there, the gist of the matter is that both the cost of living crisis, inflation, and the Fed’s raising of interest rates aren’t coming to a close any time soon. None of these facts bode well for investors in the immediate term. In fact, most economists believe that we are headed for recession sooner rather than later – if we’re not already in one now.
Is this bad news? Undoubtedly. Yet we’ve been here before, and we’ve made it out before – so let’s focus on actionable advice the everyday investor can take to preserve their capital.
There are a number of proactive steps an individual can take to prepare their personal financial situation for a situation. But while emergency funds, cutting down on expenses, and paying off debts are all positive moves, one key question remains for the DIY investor: What are the ideal types of stocks to buy in a recessionary environment?
Is There Really Such a Thing as Recession-proof Stocks?
The short answer to this question is no – there isn’t a single stock that will remain completely unaffected by wider macroeconomic downturns. In and of itself however, this shouldn’t dissuade you from investing in the stock market during an economic downturn.
With the proper approach, investors can do more than scrape by in economic downswings. Although it might seem unlikely, achieving more than just capital preservation during a recession is certainly possible.
So, what’s the key to spotting such diamonds in the rough? It all comes down to the specific sector in which the business operates. Some sectors sustain or even improve revenue during a recessionary environment.
This is a part of fundamental analysis – so let’s quickly clarify how this works.
Factors to Consider When Analyzing Stocks
Fundamental and technical analysis are the two crucial approaches used by investors to analyze stocks.
While both methods of analysis are significant and can help identify which direction a stock is more likely to go, it’s really fundamental analysis that’s more valuable to investors amid an economic downturn.
Fundamental analysis is a method which takes macroeconomic factors into account, such as the wider state of the economy, the strength of the industry, and the financial statements published by a particular company.
In this field, some of the most important factors to consider are:
Technical analysis, on the other hand, looks at historical price action. It is primarily used by day traders, and while it is an effective approach, short-term trading in a recession isn’t an approach that meshes well with the risk tolerance most investors have. Nonetheless, a few metrics should be understood at a minimum in order to understand a stock’s current momentum.
Stocks that Historically Perform Well During a Recession
Now that we’ve gone through the methodology that should be used to identify good investment opportunities, let’s narrow down the search. Although there are standout companies in every sector and industry that will outperform the competition in a recession, looking at historical data can clue us in as to which industries as a whole outperform the market in a recession.
Consumer staples are products that people need to buy regardless of the economic climate, such as food, beverages, household products, and personal care items.
Unlike some other expenses, all of the above is non-negotiable – while the average consumer will cut down on luxury items, travel, and probably postpone the purchase of a new car in a recession, consumer staples hold steady even in downturns.
Companies that produce and sell these products tend to be less affected by recessions, as demand for their products remains relatively stable – meaning that the same holds true for their income and revenue. Examples of consumer staples companies include:
Utilities provide essential services such as electricity, gas, and water, which are necessary both for daily life and the operation of various businesses and industries. Just as in the case of consumer staples, demand for these services remains relatively stable.
Additionally, many utilities have regulated pricing, which provides a level of stability and predictability for investors. A few examples of common utilities stocks include:
Discount Retail Sectors
Retail might seem like the first sector that will experience massive losses in a recession – and that is partly true, but with a big asterisk next to that ‘partly’. While consumers do make large adjustments to their shopping habits in economic downturns, this actually plays to the advantage of certain retail companies.
To be more precise, we’re talking about discount retail companies here. These companies leverage economies of scale and their size to offer a wide variety of products at prices that the competition simply can’t keep up with.
Examples of discount retail companies that are likely to outperform the rest of the retail sector include companies such as:
Healthy Large Cap Stocks
Large cap stocks are stocks of companies that have a market capitalization of $10 billion or more. In times of recession, size can definitely prove to be an advantage.
Healthy large-cap stocks are companies that combine size with strong financials, a track record of stable earnings, and they usually have economic moats – advantages that the competition isn’t likely to overcome any time soon.
Often referred to as “blue chip stocks”, these companies are household names, industry leaders, and facets of everyday life. Although none of us have a crystal ball, it’s hard to imagine McDonald’s, Coca-Cola, Apple, or IBM going out of business.
These companies tend to be more resilient during a recession, as they have the resources to weather economic downturns. What’s more, the amount of capital that they have at their disposal often allows them to make acquisitions and expand their businesses in times of recession.
Stocks to Avoid During a Recession
Just as some industries have proven to be less affected by recessions, others have proven to be particularly vulnerable to economic downturns. Focusing your investments in these industries is one of the most common mistakes when investing in a recession.
Now, this isn’t a blanket condemnation of these industries – some companies in these sectors will do just fine, and others might even excel – but investing in them during a recession is quite a risky move that most retail investors should be quite wary of.
Cyclical industries are those that are heavily impacted by economic cycles – they tend to perform well during economic expansions and poorly during recessions. These include the construction industry, the automotive industry, and the technology industry.
Companies in these industries can see significant declines in revenue and profitability during a recession which are much more pronounced when compared to the market at large.
A few examples of cyclical industries include construction, automotive, leisure, and luxury goods.
Leveraged Companies (debt)
Companies with high levels of debt can be particularly vulnerable during a recession. With reduced consumer spending, revenues drop – meaning that these companies might struggle to pay off their interest payments.
If that happens, there are two possible solutions – refinancing their debt using new loans, which is unlikely in a recession, or cost-cutting measures such as layoffs, which are much more likely. The problem is that these choices lead to a downward spiral of reduced revenue and shrinking business.
Companies that are highly leveraged may also face higher interest costs, and the sheer fact of a bad debt-to-equity ratio will likely deter most investors in times of recession.
An example of a stock to consider avoiding in this category would be Carnival Corporation (NYSE: CCL), which as of early 2023 had a high debt-to-equity ratio of 5.6.
Speculative stocks are those that are highly unpredictable and may be based on a promising but untested business model, new technology, or other factors that could be easily disrupted during a recession.
Examples of speculative stocks include emerging technology companies, biotech companies, and other startups. These stocks may be particularly risky during a recession, as investors may become more cautious and less willing to take on risk.
It’s worth noting that while these industries and types of stocks may be riskier during a recession, sometimes those risks pay off – however, extra diligence is required, and even so, these stocks will only be a choice for those with extremely high risk tolerance.
Other Favorable Assets in a Recession
Most of our focus has been on stocks – but rarely anyone holds a portfolio composed completely of stocks. What’s more, having a diversified portfolio is one of the key elements of successfully weathering a recession – so let’s take a look at some of the other assets and asset classes that can help an investor weather a recession.
Investors often turn to precious metals as a safe haven investment during times of economic uncertainty. This is because they are considered a store of value and tend to hold their value well, even when other assets like stocks and bonds are declining in value.
During a recession, governments usually take measures to stimulate the economy by increasing the money supply, which can lead to inflation. Precious metals have historically held their value during times of inflation, making them a particularly attractive investment during a recession.
Including precious metals in a well-diversified portfolio can help manage risk and potentially improve returns over the long term. There are several ways to get exposure to the precious metals industry:
Fixed-income assets such as bonds tend to be less volatile than stocks. On top of that, they can provide a reliable source of income through interest payments.
Because of their stability and predictability, investors naturally gravitate toward bonds in times of economic uncertainty. Allocating a large portion of your portfolio to these assets is a great way to ensure capital preservation.
Keep in mind that not all bonds are made equal – while government bonds, backed by the U.S Treasury, are arguably the safest investment you can find, they offer low yields. Corporate bonds, on the other hand, offer much greater yields, but come with greater risk.
It’s also worth looking into municipal bonds and TIPS. Municipal bonds are issued by local governments, typically to finance infrastructure or public projects. What makes them appealing, however, is that they are exempt from federal income tax – and in many cases, from local and state tax as well.
TIPS or treasury inflation-protected securities are specifically designed to protect against inflation – with interest based on a fixed rate, but a principal value that is adjusted according to changes in the Consumer Price Index (CPI).
Dividend Producing Assets
Investments that produce regular dividend payments, such as dividend-paying stocks and real estate investment trusts (REITs) provide a source of passive income that can help offset any losses in other parts of an investor’s portfolio.
Additionally, companies that pay consistent dividends are often viewed as stable and reliable, which can make them attractive to investors during times of market volatility.
Examples of dividend-producing assets include blue-chip stocks like Johnson & Johnson (NYSE: JNJ) and Coca-Cola (NYSE: KO), as well as REITs that invest in stable income-producing properties like apartments, offices, and shopping centers.
Incorporating at least some elements of dividend investing is a common move when economic conditions are poor. To narrow down the search, take a look at the S&P 500 dividend aristocrats index – it consists of companies that have both paid out and raised dividends for at least 25 years on end.
Beyond the fact that passive income helps to offset losses on other ends, it also gives investors capital to invest in good opportunities that they otherwise might not have been able to take advantage of.
Conclusion: Don’t Panic
We know that recessions are tumultuous periods that have a tendency to send investors into panic mode. And those worries aren’t unfounded – but the only way to avoid disaster is to make decisions with a cool head.
It is simply the nature of the market to fluctuate, even if those fluctuations are dire and negative – but the main takeaway is that the market always rebounds. If you take all of the advice we’ve given you into account, apply it in time, and remain calm throughout the turbulence – you’ll eventually find yourself in calm waters again, with minimal damage after the storm.
This content was originally published here.