In a piece we wrote last week, we argued that the U.S. economy was about to enter Japanese style prolonged stagnation. Further evidence coming out on Tuesday morning that showed an unexpected decline of .20 percent in consumer spending raises the prospect that the U.S. economy will enter a double-dip recession rather just a mere stagnation — pushing a fragile Europe and Japan into recession; and slowing down China’s and Korea’s growth substantially.
What makes this scenario particularly worrisome is that policymakers in U.S., Japan and Europe have already exhausted both their monetary and fiscal ammunition to avert or even cushion the repercussions of such a scenario.
Simply put: the world economy is heading for a recession, and policymakers have very little, if any ammunition to fight it. So, what should investors do?
A recession is normally bad for the overall equity (especially cyclical stocks) and commodity markets; and good for fixed income markets. But with interest rates at record low levels, things aren’t that simple. Here are five trades investors may want to consider:
1. Sell high-flying cyclical stocks. For more than two years, commodities had everything going their way. This is especially true for materials and precious metals: ultra-accommodating monetary and fiscal policy, a falling dollar, a growing world economy, inflationary expectations, and soaring sovereign debt. Walter Energy (NYSE:WLT) that missed on second quarter revenues by a great margin is up 600 percent since 2009. Cliffs Natural Resources (NYSE:CLF) is up 400 percent. Ishares silver trust (NYSEARCA:SLV) is up 350 percent since early 2009; SPDR Gold Shares (NYSEARCA:GLD) is up 100 percent; and Freeport-McMoRan Copper and Gold (NYSE:FCX) soared 400 percent. But the commodity rally may be over. Monetary policy is no longer ultra-accommodating, and some have raised rates (China, Brazil, and India). The dollar is stabilizing, the world economy is slowing, and inflationary expectations are tapering off. In addition, changes in margin requirements may limit the flow of funds into commodities, as was the case with cotton and silver at the end of April.
2. Avoid Chinese stocks. A global recession will slow-down for Chinese products, and may even intensify trade tensions between the two countries. Besides, as we discussed in a previous article, buying Chinese companies traded in U.S. exchanges is a high-risk strategy, as these companies are subject to frequent changes in rules and regulations that undermine their ability to stay in business and maintain profitability. Smaller Chinese companies, especially those listed through ”reverse mergers,” are conducive to accounting fraud and manipulation. This realization prompted some discount brokers to take certain Chinese stocks off the margin list last Wednesday — resulting in hefty losses for popular Chinese companies, like Youku.com, Inc. (NYSE:YOKU), Sina Corporation (NASDAQ:SINA), Baidu, Inc. (NASDAQ:BIDU), and Sohu.com Inc. (NASDAQ:SOHU), .
3. Avoid momentum stocks. Momentum investing is a strategy based on hype about an investment theme, a new product or a new industry that captures and captivates the investor mind-- at times when money is cheap. In the late 1990s, the theme was telecommunications and networking, with momentum funds flowing into companies like Cisco Systems (NASDAQ:CSCO), Ciena Corp (NYSE:CIEN), JDS Uniphase Corp (JDSU), Corning, Inc. and Ariba Inc. (NASDAQ:ARBA). Now the theme is social media and web-based companies, like Netflix, Inc. (NASDAQ:NFLX), Open Table Inc. (NASDAQ:OPEN), and LinkedIn Corp (NYSE:LNKD). Momentum investing can be very rewarding as long as it lasts. But it can result in hefty losses once it fades away, especially for investors who got in at the top.
4. Buy non-cyclical stocks — stocks that fare better during a recession like food and beverage, but stay away from medical providers like nursing home companies, which are expected to be negatively affected by deficit cuts, as discussed in a previous piece.
5. Stay away from U.S. Treasuries--and Treasury ETFs like TLT. Though U.S. Treasuries are the first investment to come in mind when the economy heads into recession. This time yields are already near record low levels, notwithstanding the impending downgrades by US. So any gains from these levels will be limited.
Disclosure: I am short NFLX, SLV, GLD.