Anyone who closely follows mainstream financial news has been seeing an ever increasing number of articles warning investors about a coming bear market. Many of this investor anxiety might be due to the fact that we have entered October, which is historically the most volatile month for market performance. After all, Black Monday happened in October 1987, seeing the DOW jump off a cliff, falling 22.61% on that day. Other articles seem to be making an argument how US tariffs on Chinese goods will put a dent on corporate profits and the US Economy. There is also the matter of increasing interest rates, in the US and elsewhere, and how it’s taken its toll on the construction and housing industries respectively. The Home Construction exchange-traded fund (ITB) is already in bear market territory, down 21% this year. All this to go along with a mountain of corporate, sovereign, and consumer debt that is putting more pressure on corporations, government’s and households ability to maintain, let alone grow, their investment, spending and lifestyle habits.

A little closer to home, there are several economic indicators flashing red. While this isn’t anything we haven’t heard before, there is now a growing amount of data to suggest Canada will experience a recession in the coming quarters ahead. Take housing for instance, for many quarters, leading the economy’s growth in GDP and labour. Well, Canada’s hottest housing market has hit an 18 year low in sales. While Toronto is the third most at-risk city in the world for a housing market correction. Considering that there is 1 real-estate advisor per 185 Canadian adults, even a small downturn in this sector will have a huge impact on employment.

So, with all that said, what can be done to adjusting our portfolios to what works well in the later parts of the economic cycle. Today we will be discussing investments you can make today that typically outperform the market going into recession.

Ditch The Growth Stocks for Stable Stocks

Whether the coming recession is small or big is almost impossible to predict. What you can do is think about which sectors offer you a degree of stability during the late stages of an economic cycle, or deep into a recession. For instance, you can assume that people will use electricity during a recession. You can also assume people will go to the grocery store and prepare dinner. People will still be brushing their teeth. Unfortunately, people will also be purchasing and using medication. That said, if we take a look at the late stages of economic cycles, healthcare, materials, consumer staples, and utilities typically outperform real estate, financial, industrial, telecom, information technology as well as other consumer discretionary stocks.

Just going to make a quick note about energy stocks here. Energy usually outperforms in such a period but could drop extremely low in a recession. That’s because in the late part of an economic cycle inflation starts to kick in, energy prices go up and that’s a benefit for energy stocks. However, during a recession, industrial demand falls, which could lead energy stock prices to really pull back, so be careful how exposed you are to this sector. That being said, because central banks around the world have kept interest rates suppressed for so many years, I do believe the inflation curve is quite far ahead from the real interest rate curve, which means that inflation is likely to linger longer in the next recession, when compared to other times of economic contraction in the past.

Switch From Expensive To Value Stocks

No matter which way you look at US equities, investors are paying higher multiples for stocks. Whether that is looking at P/E, P/Sales, P/Book or EV/EBITDA, it is clear as day that the US equity market is overbought. I understand that you have a 10-year investment plan, but that doesn’t mean you should you should have to overpay for such investments. When considering an asset re-allocation in your portfolio during the late stages of an economic expansion, consider looking at assets price to book value as well as their tangible book value. The price is what you pay, while the book value is what is on the balance sheet. These can be tangible assets like real-estate or cash in the bank, or it can be intangible like Goodwill. What typically happens in a recession is goodwill gets impaired if a company overpaid for an acquisition, so what you should be looking for is companies that are trading close to book value. In a recession, earnings get lower, drop to zero, or fall into negative territory. Therefore the only thing that can protect a stock price is the tangible book value.

One sector where investors can find a great deal of value is in the gold-mining sector. While these stocks have been in bear market territory for many years, one of the positive outcomes of this undervaluation is efficiency. Many miners have purged themselves of excess, leading to many efficiencies in their operation. Another positive for gold-miners is that compared to the tech-sector, have much lower debt to equity ratios. While there is no definite way to predict how gold mining stocks will perform during a recession, given how these assets offer investors a fantastic opportunity in relation to their book value.

Increase Your Exposure To Market Hedges

The next thing you can do is start taking advantage of higher interest rates. Lately, we have started to see the US Fed and other central banks around the world increasing interest rates, which means that treasuries are yielding more and more. This trend of rising interest rates is more than likely to continue given the huge amount of debt in the developed world, as well as the enormous amount of money that has been printed since the last recession. If you are looking for protection over the next two years, or you want the liquidity by buying short-term bonds when the next recession crisis does arrive, you will be able to buy those tech stocks, those consumer discretionary stocks at extremely lower prices. So, having liquidity cash that may yield just 1% or less, is really something to think about now. Because not only does holding short-term bonds and treasuries increase your liquidity, it helps you spread your currency risk as well, so long as you are buying short-term bonds from different nations. Depending on your risk tolerance, you can also buy put options, if you know what you are doing. Buying put options now should not be that expensive in relation to the downside.

Final Thoughts

Now, while what am saying might sound very easy, it is a simple strategy that has worked in the past and will probably work again in the future. The problem is most investors aren’t going to do it. Most people simply will not re-balance their portfolios in time. Here’s why; greed. If you invested in Nvidia in the last year, you would be up 170%. Alibaba, 66%, Wynn resorts, 42%. If you go into defensive stocks, your returns will be much lower than those named above. If you are invested in hedges, or you increase your allocation into hedges, and the economy continues to grow, you might end up with negative returns. So, even if you could lower your risk by diversifying or by hedging, many investors will prefer to stay with an aggressive portfolio, looking for those hot stocks that have real potential for further growth should the economy continue growing at these rates. However, these kind of investments are the ones that get clobbered during a recession, so it’s a decision you need to make for your self, dear investor, based on where you are in your life. What is your risk appetite? Do you need more protection, or do you need more growth and would you like to continue as things are? You need to really think about where you are in this part of the economic cycle that’s even perhaps the most important thing where you are, then it will be much easier to figure out what to do with your portfolio.

A good question to ask yourself is this: what will I do if the DOW falls 10% in the next quarter? What if it falls 30% in the next two quarters? What if everyone says this is the bottom, we will recover, central banks are printing money again, and then it falls a further 20%? How will that impact your 10-year savings plan? How will that affect your lifestyle? So you really need to think about what if the worse happens, how will that affect you, and how are you positioned for the worse case scenario. Do you have a good enough exposure to defensive assets to see this through? Are you too exposed to high-risk assets? Like justice, investing is about balance. It is an attempt to balance harm with reparation. These are the things you need to consider when adjusting your investment strategy during the late stages of an economic expansion, going into a recession.