Tuesday, March 4, 2008

How to make your Portfolio Recession-Proof

While it would be Utopian to have the economy grow at a stable rate, economic recessions are a fact of life and are as unavoidable as the setting of the sun. Like the sun, the economy goes through periods of rising (growth and expansion) and periods of setting (decline and recession).

In this article, we will look at how to properly invest as the economy moves through the setting phase - recession.

What is a Recession?
A recession can be defined as an extended period of significant decline in economic activity including negative gross domestic product (GDP) growth, faltering confidence on the part of consumers and businesses, weakening employment, falling real incomes, and weakening sales and production. This is not exactly the environment that would lead to higher stock prices or a sunny outlook on stocks.

Other aspects of recessionary environments as they relate to investments include a heightened risk aversion on the part of investors and a subsequent flight to safety. However, on the bright side, recessions do eventually lead to recoveries and follow a relatively predictable pattern of behavior along the way.

Keep an Eye on the Horizon

The real key to investing before, during and after a recession is to keep an eye on the big picture, as opposed to trying to time your way in and out of various market sectors, niches and individual stocks. Even though there is a lot of historical evidence of the cyclicality of certain investments throughout recessions, the fact of the matter is that this sort of investment acumen is beyond the scope of the ordinary investor. That said, there's no need to be discouraged because there are many ways an ordinary person can invest to protect and profit during these economic cycles.

To begin with, consider the macroeconomic issues of a recession and how they affect capital markets. When a recession hits, companies slow down business investment, consumers slow down their spending, and people's perceptions shift from being optimistic and expecting a continuation of recent good times to becoming pessimistic and uncertain about the future. As such, people get understandably frightened, become worried about prospective investment returns and rationally scale back risk in their portfolios. The results of these psychological factors manifest themselves in a few broad capital market trends.

Within equity markets, the results are pretty obvious. As people become uncertain about prospective earnings, they perceive a greater amount of risk in their investments, which broadly leads investors to require a higher potential rate of return for holding equities. Of course, for expected returns to go higher, current prices need to drop, which occurs as investors sell their higher risk investments and move into safer securities including government debt. This is why equity markets tend to fall, often precipitously, prior to recessions as investors shift their investments.

Recessions and Specific Investments
In fact, history shows us that equity markets have an uncanny ability to se
rve as a leading indicator for recessions. For example, the markets started a steep decline in mid-2000 before the economic recessionary period between March 2001 and November 2001. But even in a decline, there are pockets of relative outperformance to be found in equity markets.

When investing in stocks during recessionary periods, the relatively safest places to invest are in high-quality companies with long business histories, as these should be companies that can handle prolonged periods of weakness in the market.

For example, companies wi
th strong balance sheets, including those with little debt and strong cash flows, tend to do much better than companies with significant operating leverage (or debt) and poor cash flows. A company with a strong balance sheet/cash flow is better able to handle an economic downturn and should still be able to fund its operations as it moves through the weak economic times. In contrast, a company with a lot of debt may be damaged if it can't handle its debt payments and the costs associated with its continuing operations.

Also, traditionally, one of the safe places in the equity market is consumer staples. These are typically the last products to be removed from a budget. In contrast, electronic retailers and other consumer discretionary companies can suffer as consumers hold off on these higher end purchases.

Fixed Income
Fixed-income markets are no exception to this line of reasoning. Again, as investors become more concerned about risk, they tend to shy away from it. Practically speaking, this means investors steer clear of credit risk, meaning all corporate bonds (especially high-yield bond) and mortgage-backed securities because these investments have higher default rates than government securities. Again, as the economy weakens, businesses have a more difficult time generating revenues and earnings, which can make debt repayment more difficult and could lead to bankruptcy as a worst case scenario.

Moreover, as investors sell these assets, they seek safety and move into
Government Treasury bonds. In other words, the prices of risky bonds go down as people sell (or the yields increase) and the prices on Treasury bonds go up (or the yields decrease).

Another area of investing you want to consider in the context of a recessi
on is commodity markets. The general rule to understand about these investments is to keep in mind that growing economies need inputs, or natural resources. As economies grow, the need for natural resources grows, and the prices for those resources rise.

Conversely, as economies slow, the demand slows and prices go down. So, if investors believe a recession is forthcoming, they will sell commodities, driving prices lower. However, commodities are traded on a global basis, and U.S. economic activity is not the sole driver of demand for resources such as oil, gas, steel, etc. So don't necessarily expect a recession in the U.S. to have a direct impact on commodity prices, at least not as strong of an effect as we have seen in the past. At some point in time, the world's various economies will separate from the U.S., creating a demand for resources that is increasingly less sensitive to U.S. growth in GDP.

If you expect a recession, positioning your portfolio is quite simple. Shift assets away from equities, especially the riskiest equities like small stocks. You should also move away from credit risk in fixed-income markets and into Treasuries.

Investments and Recovery
So what to do during a recovery? It sounds too simple, but investing for an economic recovery entails doing the exact opposite as described above.


Again, keep an eye ton the macroeconomic factors. For example, one of the most often used tools to reduce the impact of a recession is monetary policy that leads to a reduction in interest rates with the purpose of increasing the money supply, discouraging people from saving and encouraging spending. This helps to increase economic activity.

One of the side effects of low interest rates is they tend to creates demand for higher return, higher risk investments. So, as recessionary expectations bottom out, pessimism fades away and optimism works its way back into people's minds. Moreover, investors re-examine opportunities for riskier investments in the context of what is usually a low interest rate environment. They also embrace risk.

As a result, equity markets tend to do very well during economic recovery. Within equity markets, some of the best performing stocks are those th
at use operating leverage as part of their ongoing business activities, especially as these are often extremely undervalued after being beat up during the market downturn. Remember, leverage works great during good times, and these firms tend to grow earning faster than companies without leverage, but they also face real risks during weakening times. Moreover, growth stocks and small stocks tend to do well as investors embrace risk during an economic recovery.

Similarly, within fixed-income markets, increased demand for risk manifests itself in a higher demand for credit risk, meaning the corporate debt of all grades and mortgage-backed debt tends to attract investors, driving prices up and yields down. Logically, U.S. Treasuries tend to go down in value as investors shift out of these assets and yields go back up.

The same logic holds for commodity markets in that faster economic growth means higher demand for materials, driving prices up. However, remember that commodities are traded on a global basis, and U.S. economic activity is not the sole driver of demand for resources.

Will the Sun Come Out Tomorrow?
To conclude, the best advice to investing during recessionary environments is to focus on the horizon and manage your exposures. It is important to minimize the risk in your portfolio and maintain your capital to invest in the recovery.

Of course, you're never going to time the beginning or end of a recession to the day or the quarter, but seeing a recession far enough in advance isn't as hard as you might think. The real trick here is to simply have the discipline to step away from the crowd and shift away from risky, high-returning investments during times of extreme optimism, wait out the oncoming storm, and have an equal discipline to embrace risk at a time when people are shying away from it to get ahead of the cycle.

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