Which investments do best in a recession?

The latest from Morningstar Investment Research Center by David Kathman, CFA . . .

Everyone seems to be worried about a possible recession these days. The specter of an economic slowdown has been hovering ever since the subprime-mortgage crisis erupted last year, after which falling home prices led to a reduction in consumer spending, or at least the expectation of one. More bad news came Feb. 5, when the Institute for Supply Management reported a sharp drop in non-manufacturing business activity in January, leading some people to think that we may already be in a recession.

Whether or not we're in an official recession (defined as two consecutive quarters of negative growth in gross domestic product), most people agree that the United States economy is at least slowing down, and it's natural to wonder what you, as an investor, should do. A recent column by Annie Sorich that was featured last month gives some good advice, which can be summarized in two phrases: Don't panic, and be prepared. A down market is usually a better time to buy than to sell, and investing steadily through dollar-cost averaging is often your best bet. Also, it's a good idea to have some savings as a cushion and to have investments in your portfolio that won't be hurt too badly by an economic downturn.

But how are you supposed to know which investments will do well (or badly) in a recessionary environment? That's not always a simple question to answer, but some general guidelines can be helpful.

Riding Out the Storm
According to conventional wisdom, the best stocks to own in a recession are those that don't depend on economic cycles and are thus capable of doing well through thick and thin. Consumer staples such as food and beverage makers are a good example, as are health-care stocks. After all, people will keep on eating and taking their medicine regardless of what the economy does. On the other hand, stocks that are susceptible to economic and business cycles traditionally do poorly in a recession; prime examples include technology, hardware, and many industrials. In a broader sense, defensive, relatively low-risk investments, such as blue-chip stocks with steady earnings, are supposed to do well in a downturn, while higher-risk investments, such as small-cap stocks, do worse. Also, hard assets, such as precious metals and real estate, are considered defensive and traditionally do well in a downturn.

For the most part, those expectations are reflected in the market's behavior so far this year, when recession fears have been highest. For example, among Morningstar's 12 stock sectors, the two worst performers have been hardware and software, with average losses of 14.82% and 14.04%, respectively, for the year to date through Feb. 8. Next worst have been energy and telecom, both with double-digit losses. Consumer services has been the best-performing sector, with an average loss of "only" 3.99%, followed by health care. When we look at fund categories, there is a similar pattern. Technology and communications funds have been the worst-performing domestic-stock categories for the year to date, while the best-performing category (apart from bear market and long-short) has been real estate, despite the weak housing market, with health-care funds not far behind.

A Mixed History Lesson
In reality, however, the markets haven't always responded predictably to recessions. That's because other factors, such as the valuations of various asset classes at the outset of the recessionary period, can affect what performs well and what suffers during an economic downturn.

For example, in the last recession, which lasted from March 2001 to November 2001, highly cyclical tech stocks sunk like a stone. At the same time, equally cyclical industrial materials stocks held up quite well, despite the widespread view that they should be avoided during a downturn. That was partly because industrials were so cheap after being beaten down during the tech bubble of the late 1990s. Similarly, small- and mid-cap stocks did quite well in 2001, even though they're generally considered less recession-resistant than large caps. Again, recent history is the reason: Small caps had been laggards in the late 1990s, so when the market began to sink, they were poised to hold up relatively better than large-cap darlings that had been priced for perfection.

Things looked rather different in the recession prior to that, which officially lasted from July 1990 to March 1991. For the trailing six months through February 1991, the best-performing funds included several health-care funds, but also many growth and technology funds, such as 20th Century. The worst-performing funds were mostly gold and precious-metals funds, because the price of gold had been falling after rising sharply the previous July and August.

Caveat Emptor
Despite some similarities, every recession is different, however. The 2001 recession followed the popping of a huge bubble in technology stocks and a great run for large-growth stocks in general; the current downturn has followed a dramatic slowdown in the housing market, and large-growth stocks, including many big tech names, have been in the doldrums for years. The 1990-91 recession played out against the buildup to the first Gulf War and fears of a possible oil shortage, but it was also a time when the use of computers and other technology was growing fast enough to overcome the head winds. When the war started in January 1991 and it became apparent that it would not be a long, drawn-out affair, the stock market jumped and the recession was over soon afterward.

These examples also show that it's not a good idea to try to time the market in reaction to a recession. Someone who was defensively positioned at the time of the 2001 recession would have been in good shape, because even though the recession officially ended in November 2001, a multitude of corporate scandals, led by Enron and Worldcom, undermined investor confidence and extended the bear market for more than a year. On the other hand, as noted above, a new bull market started even before the 1990-91 recession was over, and investors had already been dumping gold and other traditional defensive investments months earlier. The market is generally very good at anticipating both recessions and recoveries, so they're often priced into the market well ahead of time.

In the end, your best bet is to make sure that your portfolio is diversified, and be prepared to ride out short-term shocks to the market. If you have a short time horizon and are really concerned about your exposure to economically sensitive areas of the market, you can use the portfolio X- Ray tool on Morningstar Investment Research Center to get a quick estimate of your exposure.

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