What do we know about recessions?
- They cause steep declines in the stock market
- are largely unpredictable
- and make normally uncorrelated asset classes move the same direction; down.
Because correlations increase substantially in bear markets, there are very few asset classes that perform well during recessions.
This article will show how to take advantage of declining stock prices while:
1. Simultaneously reducing maximum draw downs
2. Positioning yourself to take advantage of bargain level stock prices at the bottom of recessions.
Asset Classes & Recessions
Volatility ETFs perform well during recessions, but are extremely volatile and suffer from several structural issues that make investing in them untenable. Long-Term corporate bonds are highly correlated to stock prices during recessions as fears of business declines spread to corporate bond prices. Emerging market bonds also dip along with stocks during recessions.
Long-Term US Government Bonds generally see price appreciation during recessions; they increase in price while stocks are falling. Gold tends to move independently of stocks during recessions. It may be rising or falling, but provides strong correlation gains during recessions. Adding both long-term government bonds and gold to your portfolio can help buffer the impact of recessions.
Source: Google Finance
Not all types of stocks perform the same in recessions. High quality dividend growth stocks have historically been less affected by recessions, though they still have sharp draw downs. High quality dividend growth stocks are businesses that have a strong competitive advantage and years of rising dividends. They are generally proven businesses with stable cash flows. The chart below shows how dividend growth stocks declined less than the overall stock market during the recession of 2007 to 2009. The Vanguard Dividend Appreciation Index (VIG) was used as a proxy for dividend growth stocks.
Source: Google Finance
3 Part Portfolio
Imagine you created a portfolio that invested equally in these 3 asset classes: high quality dividend growth stocks, long-term government bonds, and gold. The idea to combine these uncorrelated asset classes is not new. Harry Browne’s Permanent Portfolio is similarly constructed, with a few differences. I compare the original Permanent Portfolio to a modified approach on Seeking Alpha here.
To invest equally in these 3 asset classes (Gold, Long-Term Government Bonds, and Dividend Growth Stocks) it is important to take equal risk, not equal weight. By weighting your portfolio so that the volatility contributed from each asset class is equal, we can take the same amount of risk on each asset class, providing strong diversification gains.
Cherry picking individual high quality dividend growth stocks from 2007 wouldn’t be a fair way to gauge the portfolios performance. I prefer to invest in individual high quality dividend growth stocks using the 8 Rules of Dividend Investing which is a quantitative framework that finds excellent businesses trading at fair or better prices. Since this is not a fair way to run a backtest, the Vanguard Dividend Appreciation (VIG) ETF makes a fair proxy to use. For Long-Term Government bonds, the TLT ETF works well. Similarly, the GLD ETF works well as a proxy for gold. If you are interested in learning how to equal weight a portfolio by volatility, read the next paragraph. If not, skip it!
To equal weight your portfolio by volatility, you first must find the volatility of each investment. In our example, we have 3 securities in our portfolio (VIG, GLD, and TLT). You can find the volatility of an ETF using the ETF Replay website. From there, find 1/asset volatility for each asset. Next, find the sum of all the 1/asset volatility numbers. Divide each asset’s 1/asset volatility by the sum of all 1/asset volatilities, and you will find your weights. Alternatively, you can do calculations in excel with historical data from Yahoo! Finance.
The three part portfolio above would have the following weights by equal weighting for volatility using data before June 2006 (when this study starts).
- VIG – 30%
- TLT – 50%
- GLD – 20%
A portfolio with these weights rebalanced monthly would have performed well through today. The portfolio would have the following characteristics:
- CAGR of 8.92%
- Standard Deviation of 8.90%
- Maximum Monthly Drawdown of -11.29%
The chart below shows the performance of each of the 3 asset classes in the portfolio along with the portfolio’s performance rebalanced monthly.
Buy The Dips
“Be Fearful when others are greedy and greedy when others are fearful”
– Warren Buffett
Recessions create excellent buying opportunities. Some stocks experience significantly worse draw downs during recessions. A diversified portfolio of businesses that are trading below Net Current Asset Value is a possibility during severe recessions (like early 2009). Buying stocks at extreme discounts can lead to strong returns out of recessions. Since cherry picking deeply discounted stocks that outperform is not a very good way to test the idea of buying on dips, we will use another asset class that typically falls faster in recessions and rises quicker; emerging market stocks using the Vanguard Emerging Market ETF (VWO).
How do you buy the dips, exactly? By adding more weight to the asset class you feel will bounce highest during a recovery (VWO in this case). Add greater weight to your risky asset as the market falls from its 5 year high. The simple formula to calculate weight in your ‘recovery’ asset is:
1 – Current Market Price / 5 Year High Market Price
For example, when the market was down 40% in 2009 from its 5 year high, you would have a 40% allocation to your recovery asset (VWO in this case). As the market recovered from its 5 year high, you would sell off your holdings in VWO.
By combining a stable portfolio comprised in equal risk adjusted weights of high quality dividend growth stocks, gold, and long-term government bonds with a buy-the-dips strategy, you can effectively create a portfolio that weathers that minimizes the downside of recessions while capitalizing on the upside. A portfolio that did this would have the following stats:
- CAGR of 10.58%
- Standard Deviation of 11.30%
- Maximum Monthly Drawdown of -16.95%
The chart below shows the performance of each of the 4 asset classes in the portfolio along with the portfolio’s performance rebalanced monthly. The 3 asset class portfolio is also shown for comparison.
As you can see, the buy on dips portfolio suffers worse draw downs as compared to the normal 3 asset portfolio. It also has a significantly higher performance coming out of recessions. The performance could be enhanced by investing in individual stocks that are trading below net current asset value during recessions.
This Is The First Step, Not The Last
The portfolio outlined in this article is not without its flaws. Monthly rebalancing would reduce performance by increasing transaction costs. A good next step will be to test the portfolio with quarterly rebalancing, annual rebalancing, and rebalancing within predefined weight bands.
Additionally, the portfolio has 50% allocation to long term government bonds which are trading at multi decade low yields. Rising yields could have a negative impact on the portfolio that gold and dividend growth stocks do not compensate enough to offset. The portfolio needs to be tested with a lower weighting into government bonds. Calculating portfolio weights based on trailing twelve month volatility instead of long-term historical volatility may partially correct for this, and would very likely improve performance.
The portfolios above show a way to profit from the effects of recessions while simultaneously minimizing volatility and drawdown with returns over 8%. The core ideas behind the portfolio are to diversify, take advantage of rebalancing gains, and buy on dips.