Last year, investors endured the worst bear market since the Great Recession. And while markets are up so far in 2023, some analysts say a recession could lead to another correction. That's not to say we will get another bear market -- meaning a market that's down 20% or more -- but it remains a very tenuous time for investors.
The market still appears to be overvalued, based on its Shiller price-to-earnings (P/E) ratio of almost 30. The Shiller P/E is the inflation-adjusted, 10-year P/E ratio of the S&P 500, and its average range is somewhere between the high-teens and low-20s. That is another sign that a correction could be coming.
If you are concerned about a correction, or a bear market, but don't want to sit on the sidelines until it is over, here are some suggestions for where to invest in a potential down market.
Look for value
As a general rule, value stocks outperform growth stocks in down markets, and that was particularly true last year, in a period of rising interest rates. High interest rates make it more expensive for companies to invest, build, and expand, which is why most growth stocks struggled last year. Value stocks are typically those of more established companies with high levels of liquidity, often in industries that are more resistant to macroeconomic forces.
Over the past year, as of April 24, large-cap value stocks are up about one-quarter of a percentage point, while large-cap growth stocks are down 7%. Over the past three years, large-cap value is up 14.2% on an annualized basis, compared to 12.5% for large-cap growth.
If you are looking for stocks trading at a lower valuation, you'll want to look at a few different metrics. The price-to-earnings (P/E) ratio is one of them. The P/E ratio of a stock that's trading at a low valuation is typically under 15 -- the lower it is, the cheaper it is. Price-to-book (P/B) is another value metric. A P/B ratio below 1 means that the stock is trading at less than the intrinsic value of its assets. The price/earnings-to-growth (PEG) ratio is another metric to watch. It is basically the P/E of the stock based on projected earnings five years out. A PEG under 1 means that the stock is undervalued based on future earnings expectations.
Keep in mind, the P/E ratio is going to be higher for growth stocks, because they are expected to grow their revenue and earnings faster than the market. So investors invest in growth stocks based on their future earnings potential, which means it is not unusual to see the P/E ratios of growth stocks in the 20s, 30s, or higher.
But what you want to avoid are ridiculously high P/E ratios. If a growth stock has a P/E within its historical range, and a solid history of earnings, then it should fit what you're looking for. If the stock still has a P/E higher than average, and, worse yet, doesn't have the earnings to back it up -- that's a red flag. Because if the market does drop again, overvalued stocks are likely going to fall hard.
On the other hand, stocks that are values -- trading at a discount, whether they are true value stocks or discounted growth stocks -- are better positioned to navigate another correction.
Stick with ETFs
While attractively valued stocks in general are a good choice in a bear market, trying to pick the right winners -- those that will perform not just through this period of volatility, but long term -- is no easy task. There are certainly some great options -- names you know well, like Berkshire Hathaway, Visa, and Apple. The latter two attract growth investors, too, but they are great companies and fairly valued.
The key, as always, is to have a diversified portfolio of stocks to provide balance, with stocks that perform differently in different market cycles, yet still have long-term growth potential.
So if you had $10,000 to invest, rather than split it up into six to 12 stocks, I'd invest in three exchange-traded funds (ETFs) for diversification, balance, and growth.
One would be an ETF that tracks growth companies, like the Invesco QQQ (QQQ -0.57%), which invests in the Nasdaq 100. The Nasdaq 100 is made up of the 100 largest non-financial companies in the U.S., including its three largest holdings -- Microsoft, Apple, and Amazon. This ETF has been among the best long-term performers on the market.
Next, I would invest in an ETF that tracks the S&P 500 -- like the SPDR S&P 500 ETF (SPY -0.21%), which gives you access to the 500 largest companies in the U.S. While it includes all of the names in the Invesco QQQ, it is much broader and includes financial stocks, which typically perform well in bear markets.
The third ETF would be one that focuses on value stocks, to provide some balance in more volatile markets. A great choice is the Invesco S&P Midcap 400 Pure Value ETF (RFV -0.09%), which not only focuses on value stocks, but provides further diversification by dipping into the midcap universe. This ETF is up 2.7% year to date and nearly 1% over the past year, and has returned 31% per year on an annualized basis over the past three years.
You can do your research and find the best ETFs for you, but I would definitely recommend a diversified mix that includes a healthy dose of value.