It’s easy for investors to benefit from a stock market rally, especially when it lasts for years. Investors are only required to have a portfolio of stocks to see returns during an economy that is thriving along with low interest rates and unemployment rates being at historic lows. The main challenge for all investors is when there is an economic downturn. It’s the economic recessions that separate inexperienced investors from experienced investors. The reason for this is simply due to their investment strategy and investment plan. So, how does a rally portfolio differ from a recession portfolio? Read more to learn how.
One of the first aspects of getting a portfolio ready for an economic downturn is by eliminating companies that have high leverage and significant debt. Companies with high levels of leverage will have high interest payments and due to that, will also have high debt-to-equity ratios (D/E). Once a company’s revenue streams start to decline during a recession, payments to service the debt becomes harder and harder. For many companies, the end result is bankruptcy and a delisted stock.
Focus on companies that have as little debt as possible or companies with a low D/E, which also signifies a company has low debt. The companies with a low D/E will be impacted by the recession just like all of the other stocks, but the impact will not be as strong and the company will not have to make higher than normal debt service payments to their lenders, allowing them to weather the recession.
During a rally, tourism-based companies will thrive and so will their stock. But during a recession, their stock will be one of the hardest hit on the market. This is due to individuals canceling their plans from loss of income or because they are unsure of what the future might hold for them. Once there are signs of an imminent recession many companies focusing on tourism see revenue decline sharply. It’s considered best practice to divest all tourism-based stocks, whether they are resorts, lodging, or cruise lines.
Cyclical stocks take a severe beating during economic downturns regardless of the severity of the downturn, but what are they exactly? Cyclical stocks are stocks where the price is impacted by systematic changes in the economy and by macroeconomic forces. These are the type of stocks that follow the path of an economy when it is expanding and when it is contracting. Companies with cyclical stocks offer their customers services or products that are in demand when the economy is good, such as airlines, restaurants, and cars.
When an economy starts to shrink due to consumers reducing spending on discretionary expenses, cyclical stocks start to decline at the same time. However, the opposite is also true. When an economy is thriving, cyclical stocks also thrive.
One of the largest impacted stocks in a portfolio would be speculative stocks, whose entire value is not based on a fundamental analysis of the company or even projections of the industry. Speculative stock’s entire value is derived from investor optimism between the shareholders only.
The value of speculative stocks is supported by a bubble, with their value not being proven yet on the open market. Investors will typically buy the stocks in question under the assumption they will increase drastically in the near future due to the stock not being well known or undervalued. Speculative stocks are quite possibly the riskiest stocks to invest in during a market rally and are even riskier during an economic downturn. They are some of the first stocks to decline and also decline the fastest, leaving investors with billions in losses in a relatively short time.
Aside from the stocks to avoid during an economic downturn, there are also stocks one can invest in to reduce its impact. Typically indulgence industries fare better than the average stock during an economic downturn: the candy, cigarettes, and the alcohol industries have historically thrived during economic downturns. Although it might be slightly dark, individuals do tend to enjoy the smaller things in life when times are tough. For example, some alcohol companies that focus on stronger, harder liquors are impacted much more negatively than companies that manufacture wine and beer, mainly due to cost. An aspect of the indulgence industry that sees significant declines during a recession are casinos, with revenue dropping drastically.
When times get hard, consumers look for cheaper alternatives for everyday staples and because of this, discount stores will typically see an increase in revenue during hard times. Dollar stores, wholesale grocery stores, and overstock stores see a significant increase in their revenue and stock price as many individuals look to save money in as many places as they can. The main driving force of these industries is uncertainty when it comes to the economy and job prospects.
There are certain industries that are able to withstand the forces of an economic downturn better than other industries. One of those industries is healthcare and in particular healthcare that focuses on senior care. An aging population will need specialized healthcare at all times and companies to run healthcare facilities.
Senior facilities will typically not be as impacted by a recession as seniors simply cannot stop needing the services of healthcare professionals. This allows healthcare companies to continue to generate revenue despite an economic downturn. Patients also cannot reduce the amount of healthcare or services from such facilities, allowing the company to continue earning revenue despite other industries losing revenue. Although they still have a revenue stream during a recession, they are not 100% immune from the impact of a market decline.
Allocating your portfolios assets into lower risk equities can still result in losses due to all equities having some risk involved. But to reduce risk and volatility further, investors would need to invest in high-grade corporate bonds that offer investors much more stability and predictability. Corporate bonds offer lower returns than stocks but can have less risk and less volatility. However, there is always a risk that the corporation that issued the bond files for bankruptcy due to the economic downturn regardless of how high the rating of the bond is.
If you are looking for absolutely no risk, then treasury bills, or T-bills for short, would be a perfect substitute for corporate bonds. T-bills are a loan to the United States government and essentially a risk-free investment because the chance of the American government defaulting on its loans is zero. T-bills do, however, come at a cost. The main cost of T-bills is that they offer incredibly low returns, but at no risk. Investors will often allocate capital to T-bills to lower volatility and lessen the impact of a recession. Another added benefit of corporate bonds is that they give their holder a certain percentage each year, giving the investor an added income stream.
As with all investing, there is no strategy that is 100% recession or depression-proof. It is advisable that all investors do their due diligence before investing in any asset no matter how safe or risky it may seem. This also applies to industries, as there is no one industry that will outperform other industries during an economic downturn. Read Companies that Thrive in a Recession and Tips for the Preparation of a Financial Plan, subscribe for more business, sales and investing posts. Have a lovely day.
