subject: Picking Stocks For The Next Recession [print this page] Investing in a recession is not as difficult as most people think.
There really is no such thing as a recession-proof stock, but there are multiple ways to survive a rough patch in the stock market.
During a recession, cyclically sensitive companies tend to perform poorly compared with those whose businesses are considered more defensive. Financials, retailers, technology, and energy are examples of sectors that get hit the hardest during a recession. Investors tend to unload shares of these cyclical industries faster than counter-cyclical stocks.
Short selling is an option to ride cyclical stocks lower during a recession. Short selling involves borrowing a security with the intention of replacing it at a lower price in the future. Thus, a short seller profits when the price of a security falls. Short selling is not without risks (i.e. paying dividends, the possibility that the stock will rebound, etc.), but it is easy to see how profits can be made when asset prices are falling. Traders short stocks that are prone to decline in value during a recession.
Defensive sectors - like consumer staples, utilities, and health care - tend to outperform cyclical stocks during bear markets. The reason is that the earnings of a utility company (i.e. a power provider) or a health care company (i.e. a drug manufacturer) are less sensitive to downturns in the business cycle. Defensive stocks also tend to offer higher dividends which is attractive to investors because it provides a buffer for long positions who are not realizing capital gains during a bear market. Utilities usually pay out a large percentage of earnings as to shareholders through dividends. This higher payout ratio moderates growth during expansionary periods, but acts as a measure of safe haven during contractionary phases.
Some investors redirect their funds from equities to fixed income during recessions, commonly referred to as a flight to safety. Bonds are less risky instruments compared with equities. Low yielding instruments like money market funds, CDs, and savings accounts offer interest bearing returns at lower betas compared with equities.
Another viable alternative to investing during a recession is not to invest at all. Some investors choose to sit in cash during a recession, waiting for a market bottom to buy discounted assets. The benefits of holding cash rather than stocks are apparent; market risk is effectively eliminated and liquidity is maximized for buying devalued assets. The drawback to cash is that it is subject to inflation.
Of course, recession investing differs for each individual. Investors with a long timeframe can afford to wait to buy assets they believe to be undervalued and which will appreciate in value after the recession is over. This class of investor may be better served by identifying beaten down assets, waiting for a market bottom to purchase these assets, and holding them over an extended period of time to realize capital gains. Investors closer to retirement with a shorter timeframe would focus more on capital preservation. These investors would likely seek out high-dividend paying stocks or fixed income securities with lower risk profiles.
