The conventional wisdom suggests that during recessions you should buy food and beverage companies (Procter and Gamble, Kroger, Coca Cola), utilities (Duke Energy, PG&E), and health care companies (Pfizer, Merck) since consumers have to buy their products no matter what the economic climate. In fact on average these industries have outperformed during bear markets. However, the relationship is not an absolute one. If you look at the performance of different sectors of the economy, you’ll find that the definition of “defensive” changes over time. In the 1960s and 1970s energy and telecom companies were considered defensive industries but today they are not. Further, different industries lead the way in every recession. In 2000, for example, financial stocks significantly outperformed the broad market, but in 2008 we saw a worldwide collapse of financials. While traditionally defensive stocks have performed well during bear markets and recessions, economic expansions have lasted longer than recessions, and these same industries tend to underperform for long periods of time.
If I don’t know exactly when a recession is starting, and I can’t play defense very well with stocks, what else can I do?
If you really have to alter your portfolio, try bonds. That’s right. A bond isn’t just a piece of paper your great grandfather owns and stuffs away in an ancient drawer for his heirs to discover. Bonds can be invaluable during bear markets and recessions. From 2000-2002, when US stocks lost nearly 40%, bonds gained a cumulative 30%. Last year bonds returned 5%. But don’t just buy any type of bonds. In “flight to quality” situations, as seen in 2008, the best bet is US government bonds. From 2000-2002, investing in a middle-of-the-road US government bond mutual fund would have netted you almost 40% and over 13% in 2008.
Perhaps most surprising is the performance of stocks during recessions. Bear markets (defined as a 20% or more drop in stock prices) have accompanied recessions the majority of the time, but there have been several recessions which were not associated with bear markets. Further, in the majority of recessions, the next bull market has started during the recession. In fact the average gain of stocks from their low during the recession to the end of the recession has been 25%. Stock market returns are not perfectly synchronous with recessions. One of the reasons is that the stock market itself is one of the leading economic indicators and therefore tends to forecast recessions—it tends to drop before a recession actually begins. Also, while the NBER officially announces peaks and troughs in the economic cycle, there is a significant delay in determining when a recession or an expansion has started. The trough in the recession of 2001 (in November) was not announced by the NBER until July of 2003. By the time a recession is officially announced, there is a good chance the market may actually be recovering. While this recession may be different than previous ones, look at the accompanying chart to see the performance of the S&P 500 after bear markets. You’ll notice that rebounds tend to be fierce and quick.
I hate making predictions, but I am certain about one thing: there will be future recessions and bear markets. While it’s tempting to shift your portfolio during economic crises, the noise in the data, the lag time between the beginning of a recession and its announcement, the potential false signals, and the historical market returns during recessions suggest that it’s difficult to time the market successfully. With some historical knowledge, we can sail through future stormy markets a bit easier.