The U.S. economy experiencing a period of recession (defined as two consecutive quarters of annual gross domestic product (GDP) decline) appears to be a certainty at this point. First-quarter GDP came in 5% lower compared to the prior-year period, and the year-over-year drop in the second quarter will almost certainly be more pronounced. Many economists currently project a drop in the 40% range for the quarter concluding at the end of June, which would mark the biggest decline in the country's history.
States are easing quarantine restrictions, and businesses are beginning to reopen, but investors still have to be prepared for lingering impacts from the coronavirus pandemic. Here are three things investors should remember as they prepare their portfolios for a recession and chart their financial strategies amid the unprecedented conditions facing the U.S. economy.
1. Understand your risk tolerance and financial position
Having a sound assessment of your financial situation and level of preparedness for a challenging economic backdrop is the foundation for smart investment planning in a recession. Market volatility may present opportunities to invest in promising companies at discounted prices, but investors shouldn't be staking large, new positions unless they have a sufficient emergency fund that will allow them to weather unexpected financial shifts.
More than 40 million Americans have lost jobs since mid-March, and the economic conditions the country is facing could lead to job losses continuing at high levels in coming months. Investors should weigh whether they are at risk of losing sources of income and plan their approach to investing accordingly.
If you're in a position where you can afford to put new money into the market, recession-related volatility may present stock-buying opportunities that prove very rewarding over the long term. On the other hand, investors who are not sufficiently prepared may face unexpected financial hardships that force them to sell stocks at a loss to cover expenses -- making tough situations even worse. Make sure you have a solid emergency fund before you consider adding new investments to your portfolio.
2. Defensive investing requires a modern approach
With the novel coronavirus still disrupting business operations and the U.S. economy almost certainly moving through a period of recession, it's important to have a forward-looking view of the market and individual business performance. The old adage about past performance not determining future results is particularly relevant right now.
Some companies that appeared to have strong moats and were relatively resilient in previous downturns may not be great vehicles for fortifying your portfolio this time around. Investors have to be mindful of conditions that are specific to the current economic climate.
Some stocks that have big dividend yields, impressive payout growth histories, and low earnings multiples on paper might quickly cease to have those attractive characteristics amid considerable uncertainty and challenging economic conditions. Adding stocks that trade at low multiples or offer high yields can still be a winning defensive strategy, but it should be pursued with a heightened focus on prioritizing sturdy businesses that are capable of thriving over the long haul.
Near-term business performance is more difficult to predict at present, and that means valuation metrics, including price-to-earnings and price-to-free-cash-flow ratios, have lost some of their usefulness in many cases.
The best thing investors can do right now is identify promising companies in industries that look primed for long-term growth in a fast-changing economy. Catalysts from the coronavirus pandemic and resulting recession will accelerate some trends -- and create new ones. You might approach defensive investing with that context in mind.
3. Recessions can be a good time to invest
If you have your financial bases covered and a sufficient emergency fund in place, a recession can actually be a great time to buy stocks. Having cash ready on the sidelines allows for the flexibility to pursue opportunities as they arise, and steadily investing through a period of economic downturn can help investors build stock positions that look very cheap, even in retrospect, and even if there's substantial market volatility in the near term.
Investors who were willing to brave uncertainty over the last few months have likely already enjoyed substantial returns on many of their recent investments. The S&P 500 has climbed roughly 36.5% since hitting its 2020 low on March 23, but it's still down roughly 5.5% year to date and 9.3% from mid-February highs, and it's not unreasonable to think that market volatility will present more worthwhile buying opportunities in 2020.
With tens of millions of Americans out of work, lingering concerns about the coronavirus, and social unrest shaking many major cities, there are plenty of reasons it might be difficult to be optimistic right now. The Congressional Budget Office expects that the U.S. economy will see a significant rebound in the third and fourth quarters, but many analysts and financial officials anticipate that challenging economic conditions could persist through 2021.
While there's plenty of cause for uncertainty right now, the U.S. will eventually return to an operating keel that's closer to normal. Identifying great companies and investing for the long term is still one of the best paths to wealth creation, and the challenges currently facing the country should also create new opportunities -- and eventually give way to calmer, more prosperous times.