RSS feedNot interested in changing your whole asset allocation model or just too lazy to learn about international markets and other less popular asset classes? Confident in your stock picking ability and would rather put together a portfolio of individual names? Well, in times of economic distress, you might want to narrow your hunting grounds. Recessions, corrections, soft-landings, whatever you want to call them. They happen, but common sense and an understanding of the market forces behind them can help you to weather the storm. After which you’ll be able to take your well protected capital and snap up stocks at a bargain from your bloodied investing compatriots.
Stagnant or downswinging business climates are characterized by a contraction in spending both on the consumer and business level. Typically, the pattern works like this. Less consumer spending leads to less profit for businesses who in turn invest less in growth. What causes this? It’s hard to say. Unstable geopolitical events, shocks to the credit markets (uh oh), or just plain gravity (what goes up will usually go down… at least a little). When this does happen, the companies which will do well are those which are relatively mature and not dependent on lofty organic growth projections for their valuations. This is the where the term “flight to quality” comes from. The idea is basically, go after quality companies that can ride out the choppy economic waters. Typically speaking, these companies will even have lower P/Es at the end of an upswing as they will be the stocks most ignored when growth and wild expectations abound. For a basic look, see the following graph of the Dow Jones Industrial Average versus the NASDAQ during the internet bubble and after it burst (1999-2003).
As you can see, over the long run large caps will provide stability particularly at the end of big upswings. When the market corrects or, worse yet, enters a recession, capital preservation is the name of the game and large caps, particularly those trading at a relative value, present your best defense.
Now, for anyone watching the DJIA of late, you’ll know that even these stocks are not immune to market turmoil. Truth is, few stocks are. But, over a prolonged economic downturn, companies which provide necessities, things consumers can’t stop buying, will provide the most stability. These are the so-called defensive sectors. The standards here are food and beverage makers, the “vice” industries (porn, alcohol, tobacco), utilities and housing services (cable, telephone, etc. and no Tivo doesn’t count), and healthcare providers and medical stocks.
The list of industries I stated do come with some caveats. For example, food and beverage refers to companies which actually produce the raw food and beverages that you consume. Not restaurants and not specialty producers of food products that depend on disposable income. That being said, there are some restaurants which might play well at least at the beginning of a recession. These are the fast-food chains as they are cheaper and could attract people looking to save money on food. This theory could extend to deep discounting retailers as well as they stand to benefit from middle income people feeling a pinch in their wallets beginning to shop with them as opposed to fancier name stores (i.e. Walmart and TJ Maxx versus Macy’s). These might be more aggressive “defensive” plays at the beginning of a downturn but if things sour for any extended period of time, retail and restaurant stocks will inevitably feel the pinch.
Housing services are also difficult as some do depend on discretionary spending. For example, you can choose to stop paying for cable or spend less on your telephone. Thus, these are not pure utilities and don’t offer as much protection. A housing service which is rarely thought of might also include apartment renters and operators of rental housing. People always need a roof over their heads and they should provide stable income. As housing prices drop (a possible sign of an economic contraction), rental yields also improve which can be a boon for renters. Finally, the medical and healthcare stocks are also difficult to deal with. Big Pharma these days seems to be losing some of its clout especially with the boom in generic drug makers. It may be safer to go after makers of generic drugs than to try to use big pharma as a defensive pick. Also, medical devices could be an emerging defensive play as more and more medical care depends on lifesaving devices.
