Published by Nicholas McCullum on April 26th 2017
The current bull market has lasted 8 years. This is much longer than the typical bull market.
Further, the S&P 500’s price-to-earnings ratio is 25, well above historical averages.
Investors around the world are wondering if the next recession is around the corner. A case for this could certainly be made…
Which leads investors to wonder how they can prepare their portfolios for minimal losses.
While it’s impossible to say when the next recession will occur, investors can position themselves defensively in the event that it is coming soon.
This article will discuss three actionable techniques to position your portfolio for the next recession.
Do Not Sell!
Before describing three actionable steps to succeed in the next recession, I want to elaborate on the importance of holding your stocks during the next recession.
When the markets are dropping, it might be tempting to hold cash. The wealth-eroding power of inflation may seem less harmful than equity market risk when the S&P 500 drops by 20%.
However, there are a number of reasons why selling your portfolio holdings in anticipation of a recession is a poor investment decision.
The most notable is the opportunity cost of holding cash. Investors who incorrectly predict a market recession and sell their holdings could be left on the sidelines watching as the S&P 500 surges another 10%, 20% or 50%.
There is also the issue of capital gains tax.
Long-term investing allows for the indefinite deferral of capital gains tax, creating a ‘Buffett Loan‘ that has a profound compounding effect over the years.
Selling holdings will trigger capital gains tax, which eliminates the benefits of a Buffett loan.
Staying the course during a recession also allows investors to continue collecting dividends, which can then be used to buy more stocks on the cheap. Buying at the bottom of a recession is a fantastic way to build long-term portfolio value.
Holding onto stocks during a recession is an important component of a long-term investment strategy. The other tips in this article might not apply if you intend to sell stocks in anticipation of a recession.
The remainder of this article will discuss three specific portfolio strategies to minimize losses in market corrections and recessions.
Step 1: Target Dividend Growth Stocks
Holding dividend growth stocks during a recession is beneficial because dividends should continue to grow (in most cases) even if stock prices decline.
If a company does cut its dividend during a recession, this triggers an automatic sell according to The 8 Rules of Dividend Investing.
That begs the question – how can investors find stocks likely to continue increasing dividends during a recession?
The best place to begin this search is by looking for companies with proven track record of consistently increasing their dividend payments.
The Dividend Aristocrats are a group of such companies, with 25+ years of consecutive dividend increases.
While the Dividend Aristocrats have impressive dividend histories, they do not match up to the Dividend Kings.
Each Dividend King has raised its annual dividend payout for 50+ years. This shows both an ability and a willingness to continue growing dividends during all economic environments.
Aside from a rising income stream during a recession, there is another reason why holding consistent dividend growers is beneficial during a recession.
These stocks have historically outperformed the market indices, and much of this outperformance has occurred during economic downturns.
The following diagram and table compare the performance of the Dividend Aristocrats against the broader stock market as measured by the S&P 500 Index.
Over the past 10 years, the Dividend Aristocrats Index has returned 9.63% per year while the S&P 500 has returned 6.99% per year.
Holding dividend growth stocks should reduce portfolio losses during a recession, and boost returns under all economic environments.
Step 2: Buy Quality, Hold Quality
Owning a portfolio of high-quality businesses is another actionable way to minimize portfolio movements during a market correction.
‘Business quality’ is an intangible characteristic that combines the shareholder-friendliness of management, the stability of revenues and earnings, and a business model with profound longevity.
The stock price of high-quality businesses will not decline as much during a recession because corporate earnings will remain relatively constant. If earnings remain constant, then a stock price decrease means a corresponding decrease in the price-to-earnings ratio – which presents a buying opportunity.
Business quality can also be measured by dividend streaks, as mentioned in the last section. Companies that have grown their dividends for 25+ years are highly likely to continue growing their dividends far into the future, according to The Lindy Effect.
Another proxy for business quality is credit rating.
Third-party credit rating agencies like Standard & Poor’s or Moody’s are very selective when assigning credit ratings. Currently, only Johnson & Johnson (JNJ) and Microsoft (MSFT) hold the coveted AAA credit rating from S&P.
Of the two companies mentioned above, the poster child of a high-quality business is Johnson & Johnson. Remarkably, the company has increased its constant-currency adjusted earnings-per-share every year…
…for 33 years.
Johnson & Johnson’s product diversity (24 products with $1 billion in sales) and shareholder-friendliness (70% of free cash flow is returned to shareholders and 54 years of consecutive dividend increases) have helped catalyze this impressive earnings streak.
More detail about Johnson & Johnson’s impressive business stability can be seen below.
Source: Johnson & Johnson 2017 CAGNY Presentation, slide 53
Identifying other high-quality businesses might seem difficult.
Look for companies with long dividend histories (the Dividend Aristocrats and the Dividend Kings, for instance), strong historical performance, and durable competitive advantages.
Owning these high-quality businesses will help protect an investment portfolio during the next market downturn.
Step 3: Seek Out Low Volatility
Volatility is the tendency for a stock price to ‘bounce around’.
High volatility stocks tend to have a wider distribution of returns than their low volatility counterparts. We measure stock price volatility by the statistical metric of standard deviation.
Investors are generally divided about the importance of stock price volatility in portfolio management.
Some argue that stock price volatility presents more buying opportunities because there are more frequent drops in individual stock prices.
On the other hand, it is difficult for an investor to watch significant day-to-day fluctuations in portfolio value. Long-term investors need not worry about these fluctuations, but it can be tempting to be distracted by daily portfolio values nonetheless.
Regardless of differing views on volatility, low volatility stocks tend to decline less during a recession than high volatility stocks. Large downward movements in stock prices would increase a stock’s volatility, so the prices of low volatility stocks will be more stable in recessions.
Naturally, investors will wonder how to identify low volatility stocks without performing all the manual calculations themselves.
There are two approaches to identifying low volatility stocks: qualitatively assessing the underlying business, and using market indices.
Taking the first approach, we must first recognize that low volatility stocks tend to have low volatility for a reason.
These companies typically operate in slow-changing industries and create products and services that are in demand through all market environments.
Stocks that exhibit these characteristics and have low stock price volatility include:
- PepsiCo., Inc. (PEP)
- Kimberly-Clark Corporation (KMB)
- Clorox Co. (CLX)
- Procter & Gamble (PG)
- The Coca-Cola Company (KO)
More generally, there are entire sectors of the stock market that have lower stock price volatility on average. For instance, the lowest volatility Dividend Aristocrats have a disproportionate concentration in the Healthcare and Consumer Staples sector.
This makes sense from a qualitative perspective. Consumers will not cut back on their health or necessity spending just because corporate earnings and market indices are on the decline.
Investors can also identify low volatility stocks by looking at the constituents of low volatility indices. The major low volatility index is the S&P 500 Low Volatility Index. Its largest constituents can be seen below.
Jus like the other two techniques listed in this article, there are merits to investing in low volatility stocks when you’re not expecting a recession.
Low volatility stocks will naturally deliver superior risk-adjusted returns (as measured by the Sharpe Ratio).
Surprisingly, low volatility stocks also deliver improved absolute returns. This goes directly against what is taught in modern portfolio theory – higher risk (as measured by volatility) should deliver higher returns, all else being equal.
The outperformance of low volatility stocks shows that this is not always true in practice.
For empirical evidence of this phenomenon, consider the following chart which compares the performance of the S&P 500 Low Volatility Index against the broader stock market (as measured by the S&P 500).
The S&P 500 Low Volatility Index has outperformed the aggregate stock market in the long run.
Thus, there are merits to investing in low volatility stocks even when a market correction is not expected.
This article provided actionable steps to position an investment portfolio for minimal losses in the next recession.
However, some might argue that positioning a portfolio for a market correction is an exercise in futility.
The next recession might be years from now, be very minor, or only last a short period of time. In short, the only thing we know about the next recession is that it is inevitable.
Fortunately for investors, the investment strategies outlined in this article have not only reduced risk during bear markets – they have increased returns during bull markets.
Thus, the strategies in this article can help investors improve performance regardless of expected future economic conditions.
If you’re interested in reading more articles about defensive portfolio positioning, the following Sure Dividend articles will be helpful: