How I Plan To Profit From The Coming Recession And Bear Market

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Includes: BIL, DIA, QQQ, SPY, VGLT
by: Dividend Sensei
Summary

December's market crash was largely due to fears of a looming economic recession.

While those fears have now abated somewhat, thanks to a more dovish Fed, investors are still worried about how to plan for the next economic downturn and bear market.

So here's my personal asset allocation/investing strategy for not just surviving the next recession/bear market but profiting from it.

Once my leverage is fully gone in early 2020, I'll be putting all weekly cash into ultra-short-term Treasury Bills, but if a recession is coming, long-term Treasury bonds.

During pullbacks/corrections/bear markets, I'll sell BIL to buy the most undervalued stocks off my DVDGP watchlists, and during a recession, I'll sell appreciating bonds to do the same.

(Source: imgflip)

I've recently gotten several requests to explain how I'm personally preparing for the next recession from readers who are worried that the next economic downturn (and bear market) might be coming this year.

That's understandable, given that December saw one of the worst market crashes in a decade.

Chart Data by YCharts

In a three week period, the S&P 500 (SPY), Dow (DIA) and Nasdaq (QQQ) plunged 16% to 17% in what ultimately proved to be the worst correction since 2009 (19.8% peak decline for the S&P 500).

Since recessions always bring bear markets with them, investors are worried that even worse declines might be coming our way soon. While recessions and bear markets are unpredictable, they are also inevitable and thus smart investors need to prepare for them.

So let's take a look at my personal portfolio recession plan, which is designed to not just protect my hard earned wealth and savings but profit during recessions and bear markets. Hopefully, this can give you some good ideas about how to prepare your own portfolio to survive and thrive before, during, and after the next recession.

But to help you potentially make your own portfolio recession plan, here's a quick look at when the next downturn is most likely to start.

When The Next Recession Is Most Likely To Start

Forecasting recessions and bear markets with pinpoint accuracy is impossible, but we can use probabilistic estimates based on historical data to get a general idea which can help with long-term investment planning.

While not all bear markets are associated with recessions, all recessions lead to bear markets. So step one is trying to estimate when the next economic contraction might begin.

According to the Federal Reserve's October Senior Loan Officer Survey

when asked to assess their potential response to a prolonged hypothetical moderate inversion of the (10y-3m) yield curve, banks responded that they would tighten standards or price terms across every major loan category if the yield curve were to invert, a scenario that they interpreted as a signal of a deterioration in economic conditions." -Federal Reserve (emphasis added)

This quote explains why the famous yield curve is the best recession predictor in history. According to a March 2018 report from the San Francisco Fed, an inverted yield curve has "correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession."

(Source: San Francisco Federal Reserve)

And since the 10y-3m curve is the most accurate of all (in terms of predictive power), it's no surprise that banks use it to set lending policy. That includes reducing credit to individuals and businesses with weak credit when the curve inverts, and thus creating a self-fulfilling prophecy in which banks, fearing a recession, help cause the recession they fear.

Well, the good news is that according to that same Fed loan officer survey, banks won't pull back on lending until the 10y-3m curve inverts. The bad news is that since QE ended in 2013 the yield curve has been following the long-term decline trend line very closely. That trend, if it continues, would mean an inversion within six to 7 months (most likely mid-June 2019).

That would indicate a recession would likely begin nine to 16 months later (March 2020 to October 2020). But the point of portfolio recession planning isn't to estimate the start of a recession, but also of when stocks are likely to peak and start falling (the start of a bear market).

Historically, bear markets begin about 19 months post inversion and after stocks have risen another 34.6%. But you'll note that the range on that is a wide 11 months, which shows the limitations of market timing based on macro factors like the yield curve. That's especially true now that the yield curve is so famous that it's possible the moment it inverts stocks start falling because the media will surely trumpet that a big crash is coming soon.

But going by historical averages (and assuming this time isn't different), that would indicate the next bear market is likely to start about 20.5 to 31.5 months from now (September 2020 to August 2021).

In other words, assuming that current macroeconomic trends hold (they might not) then investors still have plenty of time to prepare their finances and their portfolios for the next economic and market decline.

The average bear market (since 1929) has seen stocks fall 30% from their peak over a period of 13 months, and then take 22 months to recover to new record highs. This is the reason why most financial planners recommend holding three years worth of cash equivalents to cover expenses, so you can ride out the bear market without selling stocks at low prices.

But now that we have a rough idea of when the next recession and bear market is likely to start, how exactly do I plan to prepare to not just survive it but actually profit from it?

My Plans To Profit From The Next Recession And Bear Market

As I explained back in early December in my final portfolio update the first step in my recession plan is "getting right with Buffett" by eliminating the use of margin from my portfolio. Unfortunately, that is going to take a while (it peaked at $139K and is down to $107K two months later).

I estimate it will take me until March or April 2020 to get to margin zero and then start executing on my new asset allocation strategy. That strategy calls for only buying quality low-risk dividend growth stocks during market pullbacks, corrections, or bear markets. Historically a pullback of 5%- 9.9% occurs every six months, while corrections occur on average every three years. So I'm not planning on sitting on a mountain of cash for years while stocks are rising (something good is always on sale and time in the market is more important than timing the market).

Instead of cash (which my broker pays virtually no interest on), I plan to keep all my weekly savings (when my margin is gone) in the SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL).

Today, this ETF (expense ratio 0.14%) yields 1.76% and has a duration of 0.1. This means that should interest rates rise 1% (highly unlikely in today's economy) it would decline in value just 0.1%. Effectively BIL is a cash equivalent, representing a risk-free asset (US Treasuries), with high liquidity that is a way of holding cash while still offsetting inflation.

BIL is where I plan to put all my weekly savings (about $2K or so) once my margin is paid off, while I wait for pullbacks or better. In the event that a recession is likely (yield curve is inverted) then instead of BIL I'll be buying the Vanguard Long-Term Treasury ETF (VGLT). This ETF (expense ratio 0.07%) has a yield of 2.7% and a duration of 18. That means if rates rise 1% it would decline by 18%, but since ahead of a recession long-term rates are falling (flight to safety and falling inflation expectations) in reality I'll be piling into long-term US treasuries when they are appreciating.

Why do I have confidence that BIL and VGLT are good alternatives to cash? Well once more I'm relying on historical data.

Since 2004 cash (T-bills) have never lost value, as one would expect from a cash-equivalent. And from 2007 to 2009, bonds also went up. How did long-term US Treasuries, in particular, do during recent recessions and bear markets?

Recession/Bear Market Year Annual 3 Month T-Bill Return Annual 10-Year US Treasury Return
1990 7.55% 6.24%
2000 5.76% 16.66%
2001 3.67% 5.57%
2002 1.66% 15.12%
2003 1.03% 0.38%
2007 4.64% 10.21%
2008 1.59% 20.1%
2009 0.14% -11.12%

(Sources: St. Louis Federal Reserve, NYU)

What you'll notice is that during the runup to and during a recession, long-term bonds do very well as investors flee to risk-free assets and interest rates fall (including thanks to Fed bond buying). Then during years when bear markets end (2003 and 2009) long-term bonds do far worse, as investors return to a "risk on" mindset and long-term rates start rising due to investors anticipating an economic recovery (and higher inflation).

Now mind you, my portfolio is still stock-focused, and I merely plan to use BIL and VGLT as low cost and highly liquid means of storing up dry powder to use during opportunistic times when the stock market freaks out and the highest quality bargains go even more on sale.

During normal economic conditions (positive yield curve) during a pullback/correction/bear market, I would begin staged selling of BIL to put the money into low-risk dividend growth stocks using the five watchlists I maintain for running my Deep Value Dividend Growth Portfolio or DVDGP. I'll be using staged buying (starting at -5% all the way to -20%) to ensure that I always have dry powder to put to work in the best opportunities my watchlists present me.

During a bear market induced by a recession, VGLT, whose duration is actually longer than 10 years, will be appreciating and when stocks hit -20% I'll begin selling my bonds to buy dividend growth stocks at fantastic prices. That buying will continue until stocks hit -30% (the historical average bottom). Should stocks fall further as occurred in 2000-2003 and 2007-2009? Well, then my weekly savings and high dividend income (also coming in on a weekly basis) will ensure I'll be buying the best high-quality bargains each week, just less of them.

Okay, so you might be thinking "sounds like a reasonable plan, but why do you think it will work?" So, here's why I'm confident in this asset allocation/investing strategy and what I plan to make my portfolio look like by the time the next bear market ends.

Why I'm Confident In My Approach

My Deep Value Dividend Growth Portfolio or DVDGP is a simple rule-based approach to buying quality, low-risk dividend growth stocks at good to great prices, opportunistically.

The companies themselves are selected from one of the five watchlists I track in my weekly "best dividend stocks to buy now" series. I'm tracking this paper portfolio as a way of testing out my future long-term strategy, since all my future savings will follow this plan. Here's what the DVDGP looks like today.

(Source: Morningstar)

As you can see it's a highly diversified portfolio, with 68 companies in all 11 sectors.

(Source: Simply Safe Dividends)

Starting in 2020, I plan to opportunistically buy companies off that watchlist confident that the combination of above average quality, undervaluation, and long-term dividend growth will combine to generate market-beating total returns.

Note that because of my highly diversified approach no single "rockstar" stock is going to help me achieve my goals, but rather the system itself. That system is built off two time-tested models, the first (Gordon Dividend Growth model), is what Brookfield Asset Management (BAM), the Berkshire (BRK.B) of hard asset money managers, has been using for decades (total return = yield + long-term cash flow growth).

I add a valuation component based on dividend yield theory, which is the only system asset manager/newsletter publisher Investment Quality Trends has been using to beat the market since 1966.

(Source: Investment Quality Trends)

Mind you IQT's 10% outperformance over 30 years is purely based on blue-chip dividend stocks (which are at least 25 years old as one of their six criteria).

I've applied my analytical skills (courtesy of covering over 200 companies per year as an analyst for Simply Safe Dividends) to including MLPs, YieldCos, BDCs, and REITs as well.

What evidence do I have that my stock picking skills are good enough to warrant effectively building a smart beta ETF? Wouldn't it just be easier to buy an ETF like SCHD and just be done with it? Well, historically, the best investors in history (like Buffett and Peter Lynch) are right 60% to 80% of the time.

(Source: Tipranks)

Tipranks tracks all my recommendations over the next year (and only for 12 months) and so far I'm hitting that 70% success rate target. Of course my actual time frame is 5+ years but unfortunately, Tipranks doesn't track that long.

The 400 stocks I've recommended over the past 2.5 years have managed to make investors market-beating returns (S&P 500 12 month return is 6.9%) 69% of the time. That's despite frequently recommending deep value stocks in hated industries, many which can take far longer to start rallying. That's good enough to put me in the top 0.5% of bloggers and top 1.6% of all analysts tip ranks tracks.

It also puts me in the same league as my fellow Dividend Kings, Seeking Alpha's REIT Guru Brad Thomas, and FastGraphs founder and value king Chuck Carnevale.

(Source: Tipranks)

But ultimately relative stats don't matter, results do. So why am I confident that DVDGP combined with a solid capital allocation strategy that prepares me to "be greedy when others are fearful" during a recession will work? Because so far DVDGP has been working just as it's designed to.

Deep Value Dividend Growth Performance So Far

(Source: Morningstar)

Granted 7 weeks is not statistically significant; however, let's not forget that we've seen some very extreme market conditions in recent months

  • 2018 saw the worst December for stocks since 1931
  • January 2019 was the best January rally since 1987 (32 years)
  • February appears to be a roughly flat month (return to normalcy)

Whether the market was crashing, soaring, or trading flat, DVDGP has beaten it, and all with a portfolio too diversified for any rockstar stock (LRCX is the biggest winner with a 30% cap gain) to explain these results.

Rather the total returns (representing stock selection) and personal returns (opportunistic buying) are what's driving this 9% outperformance so far. I'm not crazy enough to think I can maintain that forever, but my goal is 2+% long-term outperformance (doubling IQT's track record). That would be more than enough to ensure financial independence via generous, safe and fast-growing dividends, with good alpha representing the "cherry on top".

And keep in mind that the portfolio's stats are great for my goal of enjoying generous, safe and fast-rising dividends. Sure some ETFs and CEFs might be able to offer better yield today, but not can offer the kind of double-digit payout growth I'm looking for and that is likely to deliver significant outperformance in the coming years and decades.

  • Portfolio yield: 3.9% (S&P 500 2.0%)
  • Yield On Cost: 4.2%
  • 5-year Average Dividend Growth Rate: 12.0% (S&P 500's historical median growth rate 6.4%)
  • Forward 5-Year Dividend Growth Expected (according to Morningstar): 11.1%
  • Long-Term Total Returns Expected (ignoring valuation boost): 15.0% (margin of error 20%)

Bottom Line: Long-Term Plans For Any Economic/Market Environment Are Essential To Achieve Your Goals

Don't get me wrong, I'm not saying my Portfolio's Recession/Bear Market Plan is the best in the world, nor that it's right for everyone. My goal here is to show you my personal strategy, that's designed to work for my needs/goals/risk tolerance and help me achieve my personal dream of dividend funded financial independence (and eventually a 4 day work week "retirement").

The point I'm making is that successful investing requires a long-term approach, including the right asset allocation (mix of stocks/bonds/cash) that's right for you. It also helps to have a plan not just for investing in quality stocks when the economy is humming and the bulls are running strong, but also when we're in a recession and the bears are pillaging Wall Street.

No one can say with certainty when the next recession will start, much less the next bear market. My best estimates, based on the bond market (and confirmed by analyzing 19 leading indicators on a weekly basis) is we're 16 to 23 months away from the next economic downturn which could mean stocks peak in mid-2020 to 2021.

But ultimately if you have a well-constructed portfolio, the right asset allocation strategy, and most of all, the discipline to execute on your plan, it doesn't matter when the next inevitable downturn occurs.

As history's greatest investor, Warren Buffett, said

We don’t have to be smarter than the rest. We have to be more disciplined than the rest.

Disciplined investors, with the right plan, will be prepared to not just protect their wealth but prosper from the panic selling that grips Wall Street and causes even the highest quality companies to sell at ridiculously low prices.

To paraphrase a famous Latin quote ("fortune favors the prepared mind")

Fortune favors the prepared investor, so investors prepared with a good plan, quality watchlists, and large savings will eventually make a fortune.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.