Are we heading into a recession? With the stock market down nearly 20 to 30% this year across the board depending on the index that you look at, and GDP shrinking in quarter one. A lot of investors and fund managers surveyed seem to think that a recession could be on the way. Of 331 fund managers in a survey by Bank of America, 72% of them are expecting a weaker economy in the next year, the lowest growth expectations on record.
The percentage of fund managers expecting a stronger economy is at nearly all-time lows and the same with the level of risk that these fund managers are taking in their portfolios. In fact, they’re not really taking any risk at all.
I’ve recently done some research on how to invest during a recessionary period, and it’s a lot more straightforward than it leads, which we’ll get to later in this article. We’ll also talk about what sectors historically do well during recessions so that you can prepare yourself.
But how do we know if we’re going to be in a recession? The truth is we don’t know. But we can look at historical recessions, and see if there are any similarities or differences in the environment leading up to them.
What is a Recession?
A recession is typically defined as when there’s a fall in GDP in two successive quarters. In the first quarter of 2022, we had a decline in GDP. I said that in the intro, and that was the first decline since the second quarter of 2020 when the pandemic started. This was a preliminary first estimate, we’ll actually get finalized data from Q1 and an estimate of Q2 GDP from the government in July. By then we should have a better idea if a recession will be on the horizon.
Let’s take a look at the dot-com bubble back in 2000, and see if there are any similarities between back then and today’s environment.
Back in 2000, there were record low-interest rates, sound familiar, the adoption of the internet, and wide interest in technology. This allowed a lot of investment money to flow freely into many speculative startups that had no real plan, other than the fact that they were gonna call their business Xname.com. Like Pets.com or Webvan.com which were huge busts.
Actually, Webvan.com was just too far ahead of its time, it was a grocery delivery service much like what you would see with Instacart today. But back then, the margins weren’t great, and the number of customers adopting the service was far too few resulting in a huge crash when the economy suffered.
The reality is, that even though companies like Webvan ultimately went out of business, there were thousands of way more speculative startups raising capital. It’s kind of similar to cryptocurrency today. There are thousands of altcoins and meme coins coming onto the market, but my guess is that in about 10 to 20 years, there will be only a few that make it. The reason for this frothiness in the market back in 2000 was that venture capital was easy to raise, and investment banks that profited significantly from IPOs fueled speculation and encouraged investments in the tech sector.
It’s almost like I could have started my own company, a cutting-edge, high-tech firm out of the mid-west “awaiting imminent patent approval on the next generation of radar detectors that have both huge military and civilian applications”. Seriously, it was like that. Anyone was starting a company. Looking at this graph below, we can see how even back in 2000 the amount invested from VC firms was astronomical preceding, and during the crash of 2017, that number still did not surpass the level of investment back in 2000.
What Investors Missed
Investors became overly confident that these speculative companies would eventually be profitable, and overlooked important valuation metrics like the P/E ratio. In fact, at its peak, the NASDAQ Index reached a price-to-earnings ratio between 175 and 200. For context, the current P/E ratio of the NASDAQ is around 18.5, and that’s a lot closer to the median. That means valuations in 2000 were close to 10x higher than what they were today.
Imagine Tesla, which is a six hundred million dollar market cap company, valued at six trillion dollars instead. There’s also a tax relief act that passed a few years earlier before 2000 which lowered capital gains taxes in the US, meaning that people were just willing to basically “yolo” their entire investment account onto speculative investments. Eventually, though it all came crashing down as the bubble popped, and the NASDAQ dropped over 77%. Even the traditionally blue-chip tech stocks like Cisco, Intel, and Oracle lost more than 80% of their value.
By the end of the stock market downturn, it was 2002 and stocks had lost 5 trillion in market cap, and it would take a whopping 15 years for the NASDAQ to regain its peak. We aren’t exactly in a 175 to 200 P/E ratio environment right now, however, our interest rates are low and there have been quite a lot of speculative investments in the past year that many people are making due to the increase in the money supply. “NFTs, anybody?”
2008 Financial Crisis
The 2008 financial crisis was a little different, people with little to no credit history were able to buy homes with subprime mortgages. Which is just a fancy way of saying that banks were loaning out money to people that were simply too risky. There was a general consensus that real estate prices only go up, so banks were willing to underwrite loans without much due diligence on the customer.
In 2006 home prices began to fall, and the market began to struggle which then led to mortgage-backed securities collapsing in 2008, and the brutal downward economic spiral began. The S&P lost 50% from 2007 to 2009, and the DOW fell over 54% from its peak.
After all was said and done, it took roughly five years for stocks to recover.
Are We There Yet?
Okay, so where are we right now? The current state of the market and the economy is that we’re experiencing many different factors that could point to a recession in the future. For example, we’re already seeing asset prices decline, record low consumer sentiment, the stock market selling off, and a massive supply-side shock for items like baby formula, oil, and chicken.
Since world war II, there have been 12 recessions. During these recessions, the S&P 500 index has declined by a median of 24% and an average of 30% from peak to trough. That means, for us, right now, a decline of 24% from the S&P 500 peak of about 4,800 at the beginning of 2022, would bring the current S&P to 3,650. And the average decline of 30% would reduce the S&P to 3,360.
The S&P 500 is currently at 3,800 at the time I was writing this article, so there may be some more pain to come. If you don’t believe a recession is coming, you could buy the dip, it’s a pretty big dip. But who knows, it’s an unprecedented time that we live in. If anybody on YouTube tells you they know it’s going to happen, or they know that a recession is not going to happen, don’t trust them because they don’t know, I don’t know, and most people that you talk to probably won’t know either.
Investments To Look Into During Recession
There are however some investments that you can look into during recessionary times, I’m going to go over three strategies that are pretty generalized.
A lot of investing comes down to your personal risk tolerance, your time horizon, and your own personal goals. An article like this can arm you with generalized information, but you’re ultimately going to have to pick what’s suitable for you.
The first strategy is that, in general, dividend stocks perform well during recessionary times, and volatile markets because regular dividend payments are a sign that the company’s cash flow is consistent and strong. In other words, they are stable companies. It’s also important to note that dividend stocks are typically less volatile than non-dividend-paying stocks, since you’re getting set payments at a regular interval, the dividends should help mitigate volatility within your portfolio.
Sectors That Outperformed The Index During Recession
However, if you are really young, a full dividend portfolio might be too conservative of a strategy because it won’t have much upside. When it comes to specific detectors of the market, Goldman Sachs found that during the past five recessions, energy, consumer staples, healthcare, and utilities consistently outperformed the index.
For instance, consumer staple companies typically do better in recessions, because they produce goods or services that have relatively inelastic demand. Meaning that there’s almost always demand no matter how good or bad the economy is doing. An example of a consumer staple company would be PnG or Procter and Gamble, they make Tide detergent as one of their products, and no matter how good or bad the economy is, “hey you gotta wash your sheets right?”
Out of all the sectors in the S&p 500, only one sector has positive returns, 12 months before a recession, through the recession, and after the recession. That’s the consumer staples sector. I did some digging into these four sectors and also found that two were trading under their 10-year historical average valuation, and that would be utilities and energy. While energy has done really well this year, it’s possible that as the energy crisis continues, the energy sector will continue to outperform.
If you plan on getting some exposure to these sectors, you could just invest in a sector ETF rather than individual stocks in the sector.
Dollar-Cost Average (DCA)
Another strategy is just to dollar cost average into the index. This is my favorite strategy, and what I do. Historically, the S&P 500 becomes a good value around the P/E ratio of 15 to 17, and the current P/E ratio of the S&p 500 is 19.33. Basically, if I see the S&P 500 dip to around 3,500, that’s probably when it becomes a good value for me to DCA into the market. But just because it’s good value doesn’t mean I won’t continue my regular investments.
If you have read my other articles, you will know that investing regularly and consistently is the best way to ride out volatility and grow your investments for the future. A P/E ratio of 15 was last seen during the 2008 recession, while I don’t know if we’re headed for that type of territory quite yet, I think investing in the 17 to 18 P/E range, and really anything under 20 P/E will give you a solid long-term entry.
What To Do
For a lot of people, the best move might not be to make any changes to your portfolio. If you are making huge changes right now, but you’re invested for the long term, you actually might miss out on some gains. Bank of America found out that since the 1930s if you set out the 10 best days per decade, your returns would be just 45% versus almost 20,000%.
They also found the probability of losing money over one day in the stock market is a little worse than a coin flip around 46% percent. But the probability of losing money in the market declines to just 6% if you’re invested for 10 years. While watching your investments drop day today sucks, selling out of the market brings the risk of locking in or realizing your losses.
Another reason to stay invested is that traditionally, the best days in the market follow the worst days, and it’s truly impossible to perfectly time the market.
JP Morgan found that seven of the best 10 days in the market occurred within two weeks of the 10 worst days in the market. For most people invested for the long term, when markets are down it’s better to not touch their portfolio. Obviously, if you need liquidity or you have some sort of emergency, you might have to. Chances are, you’re actually saving yourself a lot of money by not doing anything. Peace and Happy Investing!
Related: 10 Investing Must Do’s