By now, we’re desensitized enough to the word “recession” that the mention of it doesn’t send us into a tailspin. The current probability of a U.S. recession in the next 12 mos is 60% (according to a Bloomberg composite of estimates). That probability has risen steadily over the last six months, and as it stands, the S&P 500 is down 19% YTD and taxable U.S. bonds are down 16% YTD. Yuck.
But remember the typical order of events: the market falls first, then earnings get hit, and the economy bottoms last.
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This week is one of the most, if not the most, important week of earnings season. So far, it hasn’t been great for large-cap technology companies, which are an important litmus test for the current and future tone of company guidance. The Q3 expectations for broad S&P earnings were already pretty low, somewhere between 3-4% year-over-year growth, and if we remove the Energy sector, growth would be negative. I expect further downward revisions and some notable misses this quarter and next, which is likely to challenge the market rally and bring corporate margins down.
Here’s the good news: that means we’ve started ticking the box on “earnings get hit.” As we move through that process, next up we’ll likely see the economy hit the skids in a bit more dramatic fashion than we’ve seen thus far. There are already several classic recession warning signs in place, and the risks that still lie ahead are bringing the likelihood of an actual recession closer into view. Note that a recession is not certain, and there is still a chance we avert one, but this article focuses on what to do if one does materialize.
As investors, we have two choices. We can run screaming into cash and cover our eyes until it’s over, or keep our wits about us and position our portfolios for the different market phases we may go through. I think it goes without saying, we should choose the latter.
Carving Out Opportunities
That brings me to the question: Which parts of the market tend to do better before, during, and after a recession? I’m taking a 30,000-foot view and listing broad asset classes, and the patterns here are clear. This table includes average performance over the periods outlined for all recessions back to 1926.
First, many might be a bit disenfranchised with bonds because it seems like they failed us horrendously as diversifiers in 2022. And they did. But that was coming off of a 40-year rally in the bond market and years of interest rate levels so low that bonds had nowhere to go but down once tightening began.
The so-called “re-rating” in both stock and bond valuations this year makes bonds again an attractive piece in your portfolio puzzle. Just take a look at the average returns for long-term corporate and long-term Treasury bonds during a recession, and compare those to the average returns for stocks. If you believe that a recession is coming in the next 6-12 months (I fall on the sooner-rather-than-later side of that coin), this is a time to build or add to high quality bond positions.
Second, it’s not about exiting the stock market. In fact, for long-term investors, it’s rarely about exiting. It’s more about where within stocks you want to put your money in order to avoid some of the downside, and participate in the upside when things recover. The table shows quite clearly that large-caps, typically thought of as more stable and steady, do better before and during recessions, but they’re left in the dust by small-caps after the recession ends.
Small-caps are generally riskier, more economically sensitive, and more volatile than large-caps, so it should be no surprise that they lead in early phases of economic expansion. The surprise usually comes from investors who didn’t have an allocation and miss that upside opportunity. It may feel uncomfortable, but before year-end, I believe it’s time to get a position in small-caps into your allocation. More specifically, I’d use a low-cost ETF, and preferably one that tracks the S&P 600 index since companies have to pass a profitability requirement for inclusion.
Lastly, something that’s not in the table, but is worth mentioning, is sector performance. This is another way to think about arranging your stock allocation, especially the large-cap portion. For the period heading into a recession, the best performing sectors tend to be Healthcare, Staples, and Utilities—classic defense. Whereas coming out of a recession, the strongest performers tend to be Materials, Discretionary, and Financials—classic economically-sensitive groups.
This is in no way exhaustive of all the positioning options that are available for pre-, during, and post-recession, and there is no such thing as a magic potion. But one of my favorite quotes is “what got you here won’t get you there,” from Marshall Goldsmith. As 2023 draws near, and the time when we will finally answer the recession question also draws near (in my opinion), it’s important to heed the advice the market has given us in past recessions. If your portfolio doesn’t include some of the classic recession and post-recession plays, it’s time to throw them in the witch’s brew and stir.
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