This article is excerpted from Tom Yeung’s Profit & Protection newsletter. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
It’s Official. Experts Finally Agree About a Recession.
On Wednesday, a Federal Reserve economist published a paper concluding that the U.S. economy has a “two-thirds probability of a downturn over the next two years.”
JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon put it more bluntly:
“That hurricane is right out there, down the road, coming our way,” the bank boss told analysts and investors earlier this month. “You’d better brace yourself.”
These sudden revelations by regulators and CEOs echo what I’ve been saying since October 2021:
We’re in trouble.
But it’s not the time for regrets.
Instead, with the probability of a recession still on the rise, it’s best to prepare for the turbulent times while keeping an eye out for profit opportunities.
7 Ways to Prepare for a Recession: The Investor’s Guide
You’ve heard these tidbits of recession advice before.
“Invest for the long-term and ignore the bumps…”
“Recessions don’t last forever…”
“Don’t try to time the market…”
Odds are, much of this well-meaning guidance rings hollow.
Markets are clearly in turmoil. Inflation is running at 40-year highs, housing and transportation are at their least affordable in U.S. history and more than 120 firms in the Russell 3000 presently trade below cash value.
You want us to do nothing?
No. Instead, there are ways to prepare (and even thrive) during a recession.
Just ask Michael Burry or John Paulson of The Big Short fame. They shorted the housing market in 2008 and made millions off the courage of their convictions. Or take a glance back at my recommendation to buy Hertz (NASDAQ:HTZ) at $2 in 2021 when demand for rental cars hit rock bottom. Those wagering on the penny stock would have earned 1,200% on their bet.
Now, I’m not asking you to short the housing market or make some other outsized wager. (If you’re interested, sign up for my newsletter where I often cover these big winners).
Instead, we’ll consider how to safely play the market while leaving the door open for big winners.
1. Build Emergency Savings
First, the usual disclaimer:
Have at least three months of cash on hand (or 6 months if you have children) during recessionary periods in case you lose your job.
Since 1948, the U.S. unemployment rate has risen 3.9% on average during economic slowdowns. A similar contraction today could see 6.2 million Americans losing their jobs — greater than the populations of Colorado or Alabama.
To compound the misery, the average length of unemployment also rises during these periods. According to data collected by the U.S. Bureau of Labor Statistics, a typical worker takes an extra 15 weeks to find work in recessions.
In other words, investors need to have a plan B should they lose their monthly income.
Fortunately, most financial advisors agree that “cash on hand” can include a wide variety of liquidity options. Money market accounts… multi-generational lending… even high-limit credit cards can count towards “available cash on hand.” As long as it’s available in times of need, an investor’s cash can come in virtually any form.
2. Get Your Cash Flow House in Order
My recessionary rule of thumb is “have a 10% monthly cash surplus.” Those with annual after-tax incomes of $100,000 will need $833 surplus per month… $200,000 will require $1,667, and so on.
- Delay large discretionary purchases. A new house or car? Unless you truly need one, these significant assets tend to decline in value during recessions. The Mannheim Used Vehicle index has already slipped 6% since January.
- Pay off debts, especially those with variable interest rates. Credit card interest rates rose 25% faster than the effective federal funds rate in the last economic cycle. Talk to a financial advisor about locking in rates for student debt, ARM mortgages and 401(k) loans.
- Create a “sweep” account. Most banks offer services that automatically transfer excess cash into savings accounts. Make use of them.
And I get it… saving money is hard. A flight to Disneyland from my Massachusetts hometown now costs more than the stay itself. But if you want to recession-proof your portfolio, it helps to also recession-proof your lifestyle.
3. Prioritize Investments in Low-Volatility Sectors
Next, a perhaps counterintuitive piece of investment advice:
Buy-and-hold investors should avoid S&P 500 and Nasdaq ETFs during recessions. These market-weighted indices have excessive exposure to tech stocks, a sector that historically underperforms during recessions.
According to a study by Fidelity, tech has underperformed the market by an average of 10% during recessions since the 1960s. And rate tightening in 1969 and 1999 coincided with tech stock crashes the following year.
Meanwhile, humdrum companies tend to do better during economic contractions. This year, the Dow Jones index of large industrial companies has lost only half the value of the high-flying Nasdaq. Long-term investors seeking diversification should consider adding to sector-specific holdings instead:
- Consumer Staples. Companies like McDonald’s (NYSE:MCD) and Walmart (NYSE:WMT) tend to outperform the market by 15% during recessions.
- Utilities. Electrical utilities and waterworks generally pass higher costs onto customers during inflationary periods. The sector has outperformed by 7% during recessions.
- Telecom. Few consumers cancel their internet or phone connections in recessions. Telecom companies outperform by 5.5% during recessions.
- Health Care. This essential sector outperforms by 5% during recessions.
4. Avoid “Buying the Dip” Until The Fed Starts Easing
Since 1950, only six of the 17 worst bear markets turned around during tightening cycles, according to strategists at Goldman Sachs. The other eleven would only recover after the Fed started easing rate raises.
In other words, investors should wait until the Fed starts signaling the end to rate rises before jumping into risky bets or tech-heavy ETFs. Investors should be prepared for further rate increases later this summer and into the fall as the Fed works to defang inflation.
A similar pattern has emerged in the world of cryptocurrency. Liquidity from Covid-19 stimulus checks helped trigger a stampede into Bitcoin (BTC-USD) in 2020. And when I warned that Jerome Powell was signaling the top of the market in October 2021, it only took another month for crypto markets to initiate their downward tailspin.
Not every sector has fallen so quickly. Companies like Dollar General (NYSE:DG) catering to penny-pinching consumers have seen shares rise 11%. And exceptional cases like NVIDIA (NASDAQ:NVDA) have benefited from unprecedented consumer demand.
But unless there’s a good reason to buy a risky stock, investors are better off waiting until a later stage of the recessionary cycle.
5. Learn to Identify Moonshot Opportunities
So, what are good reasons to buy risky stocks? Here’s where the concept of “Moonshot” investing comes in.
Moonshot investing involves finding companies with limited downside but enormous upside. My investment in Hertz had perhaps a 30% to 50% chance of going from $2 to zero. But the potential 10x upside to $20 far outweighed any possible risks. The same was true for other recommended winners such as Longeveron (NASDAQ:LGVN), Enservco (NYSEAMERICAN:ENSV), Volt Information Science and other low-priced stocks.
To get you started, here’s my playbook for finding these big winners during recessions:
- Trading below net asset value. Stocks like Desktop Metal (NYSE:DM) can become so cheap that investors can scoop up shares for less than the value of the firm’s underlying assets. At $1.50, an activist investor could theoretically have bought DM and liquidated it for a larger amount.
- Hidden turnarounds. Long-term laggards like AT&T (NYSE:T) can disappoint investors for so many years that share prices fail to reflect an ongoing turnaround.
- Unusual assets. Markets often have trouble valuing complex firms such as Bausch + Lomb (NYSE:BLCO) during periods of high volatility. These unique firms can temporarily become worth less than their subsidiaries and IP.
- Inflation winners. Belt-tightening consumers often turn to discount retailers like RealReal (NASDAQ:REAL) to outsmart inflation.
- Recession-agnostic. Firms like Crowdstrike (NASDAQ:CRWD) can perform well since cybercriminals tend to ignore the Fed.
And if you’re interested in getting more of these picks, make sure to sign up for my newsletter here, where you’ll also receive a free copy of my latest report, 17 High-Potential Penny Stocks for Promising Long-Term Gains.
6. Diversify Into I-Bonds, but Avoid Corporate Debt
At the other end of the spectrum, rising rates have turned traditionally “safe” assets on their heads. Bonds, treasuries and cash are now some of the worst places to store wealth.
Since the start of the year, the Bloomberg U.S. 10+ Year Corporate Bond Index has fallen by-19.3%, wiping out almost three years of gains. Long-term treasury bonds have done even worse, with the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) down 24% this year.
The underlying problem comes from the combination of inflation and rate hikes. Inflation decreases the value of cash, while rising rates lower the value of fixed-rate long-term bonds. It’s a “perfect storm” situation where fixed-income assets are almost guaranteed to end up underwater (unlike financial crises, where rate cuts raise the value of fixed income).
Meanwhile, inflation-protected bonds and other variable-income assets are far more attractive. Government-backed Series I Bonds presently yield 9.62%, thanks to their mandated link with inflation. Though investors are limited to buying $10,000 per year of Series I bonds, conservative investors should still make room for these stable winners in their portfolio.
7. Don’t Panic
Finally, investors need to keep a cool head. Losing 50%… 70%… 90% on a stock can easily spur even the most experienced investors to rash decisions.
Researchers highlighted this exact fact in the most recent issue of the Journal of Financial Data Science. Tracking 653,455 individual brokerage accounts, a team at MIT found that investors are unsurprisingly prone to “freaking out” during drawdowns. Of those accounts that dropped at least 90%, more than 50% of the losses were due to trades.
Similar studies have found evidence of emotional damage before. One large-scale U.K. survey published earlier this year concluded that “emotions and personality are good predictors of investor reactions to market crashes.” In other words, researchers could predict how investors would handle recessions just by measuring their levels of extraversion.
Markets today will likely get worse. The effective federal funds rate still sits at 1.75% — far lower than the 3.5% to 5% economists believe is needed to tame inflation. And share prices still sit 15% above long-term averages.
But once the Fed tightens another 2% or 3% and the world feels like it’s ending, just remember Douglas Adams’ timeless advice from Hitchhiker’s Guide to the Galaxy:
When to Start Buying Stocks?
According to a study by Kiplinger, the best time to start buying stocks is actually when the NBER announces the start of a recession.
“Often, by the time the bureau has figured out the start of the recession, it’s close to the end,” the researchers noted. “Many times, investors anticipate the beginning of a recovery long before the NBER does, and stocks begin to rise around the time of the actual economic turnaround.”
My personal research backs them up. Analyzing U.S. recessions since 1950, I found that stocks typically start rising about three months before the end of a downturn. Markets are relatively effective at anticipating future recoveries.
Such findings also show that it still isn’t a good time to jump back into stocks wholeheartedly. Just as they did in October 2021, the Fed is still signaling more rate rises. Investors would do well to listen.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.