Despite each of the major U.S. stock market indexes hitting fresh all-time highs in recent days, warnings of recession continue to fill the air.
For example, in recent months we witnessed a couple of short-term inversions of the yield curve -- a chart depicting yields on U.S. Treasury bonds of varying maturities. Typically, we'd like to see an up-sloping curve, with longer-maturity bonds having higher yields than short-term notes. But throughout 2019, this curve flattened out, then briefly reversed, with short-term Treasury notes sporting higher yields than long-term bonds. A yield-curve inversion has preceded every recession since World War II, although not every inversion of the yield curve since then has been followed by a recession.
Manufacturing data has also been notoriously weak of late. The ISM Purchasing Managers Index for October marked the third consecutive month of contraction in the manufacturing sector, while the September reading was the weakest we've seen in more than a decade. Thanks to technology, manufacturing doesn't hold the same importance to the U.S. economy that it did, say, three or four decades ago, but contraction in manufacturing can still have some seriously negative repercussions.
Recessions are inevitable, but you can still outperform when they strike
Suffice it to say that it's not a matter of if a recession will occur, but merely a matter of when.
However, this doesn't mean it's time to pack up your things and run for cover. Trying to time the stock market is probably the single worst action you could take an investor, as demonstrated by J.P. Morgan Asset Management's annual analyses on stock market volatility. Every year, its analysts find that missing even a small number of the market's best days while trying to avoid the worst days can lead to substantially lower long-term returns.
So, what's the game plan to not just survive, but thrive, during a recession? It's simple. Seek out the following three types of investments:
- Basic-need goods and services stocks
- Dividend stocks
- Value stocks
Basic-need goods and service companies
The first game plan would be to seek out companies that provide basic-need goods or services. These tend to be purchased at predictable levels no matter how well or poorly the U.S. economy is performing. Examples might include detergent, toothpaste, toilet paper, and electricity, all of which are basic necessities for consumers in any economic environment. Basic-need companies are likely to underperform during stock-market booms, but they often prove their worth during the inevitable corrections.
One such standout is NextEra Energy (NEE 0.23%), the largest publicly traded utility in the United States. NextEra provides electricity and gas to around 10 million people, and its business model is protected in a variety of ways. The company's traditional electric business is regulated, which is just a fancy way of saying that it needs approval from state electric commissions before raising prices. Though this might sound like an impediment to growth, it's actually great news, since it keeps NextEra from being exposed to potentially volatile wholesale-market pricing.
On the other side of the aisle, NextEra has the largest renewable energy business in the country. No other utility generates more from wind or solar than NextEra, which is important since these renewable options have substantially lower operating costs than traditional electricity generation methods. These renewable projects are a big reason that NextEra Energy can continue to outpace its peers in the growth department for the foreseeable future.
Next, consider adding (even more) dividend stocks to your portfolio.
Dividend stocks offer a plethora of advantages over their non-dividend-paying peers. In no particular order, dividend stocks:
- Historically outperform non-dividend-paying stocks
- Are often profitable
- Have time-tested business models
- Can help calm skittish investors by hedging some of the downside when corrections strike
- Allow for dividends to be reinvested into more shares of dividend-paying stock, compounding your wealth
Although there are hundreds upon hundreds of dividend stocks, they're certainly not all created equal. But if there's one that stands head and shoulders above the rest in terms of safety, it's healthcare conglomerate Johnson & Johnson (JNJ 0.41%).
Johnson & Johnson is among the most elite of Dividend Aristocrats in that it's raised its payout for 57 consecutive years. The company has also reported an increase in adjusted operational earnings growth for 35 straight years (as of 2018), and is one of only two publicly traded companies with a higher credit rating (AAA) than the U.S. government (AA).
What makes Johnson & Johnson tick is its three operating segments, each of which brings something important to the table. J&J's consumer health products segment is a slow-grower, but it generates highly predictable cash flow. The medical devices segment is generally low-margin now, but offers plenty of long-tail growth opportunity with America (and the world) aging. Lastly, pharmaceuticals provide the bulk of J&J's high growth and margins, but that's kept in check by the finite time frame of brand-name drug exclusivity.
A third way to tie everything together is to seek out value stocks -- companies perceived to trade at a discount to the broader market, their peers, or perhaps their own historic metrics. When recessions strike, Wall Street and investors place added emphasis on operating results, so aggressively priced growth stocks can take a hit. This is why companies that are perceived to be inexpensive can outperform.
Take tobacco giant Philip Morris International (PM -1.48%) as the perfect example. At a price of approximately 15 times next year's earnings per share, Philip Morris might not appear cheap initially. However, this is notably lower than the forward price-to-earnings ratio of the S&P 500, and is also lower than Philip Morris' five-year average forward P/E, which is north of 18. We have to go all the way back to 2014 to find the last time Philip Morris was priced this inexpensively, based on forward P/E.
In addition to being a value stock, Philip Morris also hits on the other two core focuses. It pays an exceptionally high, yet wholly sustainable, dividend yield of 5.5%, and provides a good (cigarettes) that has little elasticity relative to the performance of the global economy. Consumers will keep buying cigarettes due to nicotine's addictive nature, which makes tobacco a highly recession-resistant industry.
In sum, a recession doesn't mean "run away" for investors. It simply means that you have to be smart about where you're putting your money to work.