This article provides investors with some basic advice on how to prepare for a downturn in the stock market as well as a recession. The most important thing is to minimize risk and protect capital. There are some steps that investors can take, but it is necessary to prepare in advance. Once the downturn starts and gains momentum, it might be too late to take defensive measures.
The Economy Is Slowing Down
The signs of an impending downturn are numerous and very clear. An inverted yield curve is a reliable signal that a recession will follow in 9-12 months. The global economy is slowing down, according to numerous indicators. Global sovereign and corporate debt are extremely high, and debt slows growth. US federal debt is over $22 trillion and climbing. State and local debt are high. Consumer debt in credit cards, automobile loans and student loans in addition to mortgage debt are extremely high. See the US debt clock.
In other words, consumers are highly leveraged. As the US economy is approximately 80% dependent on consumer spending, the prospects for growth are limited. The Fed has become dovish and postponed planned interest rate increases even though QT (Quantitative Tapering) is supposed to continue until September. This will result in decreased liquidity in the economy. When one adds to all these points the need of the Treasury to finance what will probably be almost a trillion-dollar deficit in 2019 and more than a trillion in 2020, a downturn is highly likely. Lance Roberts advises caution in an overbought market.
The Stock Market Is Overbought
The stock markets wobbled from October to December 2018 and almost entered bear territory in the first half of December, only to rebound with a Christmas rally that carried into the first quarter. Previous highs are now within reach. This can lead investors to be complacent and think that the market is going on to reach new highs. The conclusion to be drawn in this case is that the stock market can continue for a very long time to ignore fundamentals and go its own way.
While prices are still high, and in some aspects overvalued, it behooves investors to prepare for a downturn, especially since the present "recovery" has lasted a very long time. There are those who think that one need no longer be concerned about business cycles and cite the example of Japan, where the central bank has practically eliminated price discovery in the markets. Even if one were willing to concede that business cycles are not a factor to be concerned about, there are still credit cycles that can cause recessions. It is clear that President Trump wants the stock market to continue to reach new highs. He has also put pressure on the Fed to keep interest rates low. He is, however, running a real risk politically to measure his success with the results of the stock market.
Gold Is a Good Hedge and Will Become Better
What investors should know is that the BIS, through the BCBS, has now revalued the percentage of the value of gold bullion that can be included in the calculation of reserves of central banks from 50% to 100%. The recent acquisition of gold bullion on the part of the PBoC and BoR as well as some other central banks will have as a result that the reserves on their balance sheets will increase and the attractiveness of gold bullion for central banks will also increase. It is highly likely, therefore, that the price of gold will increase as a consequence, and physical gold as opposed to paper gold will be in high demand. This is a good reason for investors to increase their physical gold holdings. If in the recent past a 5-10% ratio of physical gold in one's portfolio was reasonable, a possible defensive measure in the present environment would be to increase gold holdings to 10-15% of the portfolio. This change is based on the assumption that there is going to be a downturn before the end of H2 2019 and that the price of gold may increase. Physical gold is still a hedge and safe haven in stormy weather.
Bonds Fare Better in a Downturn
The traditional 60/40 portfolio ratio (60% in fixed income and 40% in equities) has been discarded by many investors, who have profited nicely from the stock market recovery from the depths of 2009. Stock prices are back to high levels, one could even say inflated levels, thanks to QE1, QE1 and QE3 as well as ZIRP and NIRP. Stock prices have gone up despite the recent Fed interest rate hikes. Given the likelihood of an approaching downturn, a shift from over-reliance on equities to a more conservative policy favoring fixed income could be appropriate. Treasury bills are still bringing in a yield close to 2.5% and are practically without risk. They will continue being attractive until the Fed starts lowering rates. This is probable in the event of a downturn. Some investors may prefer to lock in ten-year Treasury notes now rather than wait until the rush when the Fed does start lowering interest rates.
Weed Out Risky Bonds
Of course, the corporate bond sector is more attractive in that higher yields are available, but here caution is advised. The time to start culling is now. There are many companies that are highly leveraged, and they will have problems in rolling over their debts (bonds and loans) over the next five years. In this time span, over five trillion dollars will have to be refinanced. It could be a good idea to divest oneself of bonds as well as stocks of shale oil producers, as they are extremely highly leveraged. It is unlikely that they will be able to pay back their debts. The shale oil industry is basically a Ponzi scheme. Then, there are a lot of companies with large sums of high-yield bonds outstanding, so it is likely that in a downturn the default rate of high yield bonds, which currently is quite low, is going to increase. It is also the case that the number of companies with bonds rated BBB, close to junk bond status, is very high. See the chart below.
The ratings of corporate debt have deteriorated since 2002.
Prudent investors will be concerned to improve the bond rating levels of holdings in their portfolio. There are hardly any corporate bonds rated AAA. The yields of AA-rated and A-rated bonds will be lower, but the risk involved in holding such paper is much less than bonds with a BBB rating or worse. There is also the risk that BBB bonds could be downgraded to junk status. In a downturn, it is better to be safe rather than sorry.
Avoid Companies That Are Highly Leveraged
Those investors who stick to blue chip stocks have much less to worry about in a downturn as blue chips continue churning out dividends and suffer less when the market swoons. The exception is companies that are highly leveraged. What should be done is to check on the debt levels that companies have and how much they are leveraged. Highly leveraged companies will have difficulty paying dividends when profit margins shrink and debts still have to be serviced. This is fairly obvious, but investors often neglect to do their homework. Then, there are companies that have carried out massive share buyback programs which have resulted in higher EPS figures as well as higher P/E numbers. These companies have invested less in R&D, in wise M&A decisions and investing in their personnel. That makes them more vulnerable when the economy slows down. If that happens, that will mean lower profits and less money available for share buybacks. It is now a commonplace that share buybacks have held up the market since the GFC. If corporations have less cash available for buybacks, the market will suffer accordingly.
A Good Recipe for Your Portfolio
The recipe for successfully confronting an economic slowdown, therefore, is first to increase holdings of precious metals as a hedge against capital loss. Holdings in fixed-income securities should be increased, while improving the level of ratings of the companies that have issued bonds. One should try to sell high yield bonds while the prices are still good and also try to limit the number of BBB bonds. It is better to shift to companies that have better ratings. In an economic downturn, the BBB ratings may be downgraded to junk bond status. This was noted above. At the same time, the percentage of capital invested in equities should be reduced and the highly leveraged companies should be removed from the portfolio. The reason for doing this is that such companies are more likely to reduce dividends in a downturn.
Cash Is Cash
It could also be prudent to increase the amount of cash as an additional hedge. It is uncertain that the markets will continue to go up in the near future. The process of adjusting one's portfolio in order to adopt a more defensive posture could take some time. How much time is left before the downturn begins is an unknown quantity. Investors should begin now to take defensive measures.
When there are signals of an approaching downturn, it behooves investors to take defensive measures to protect their capital. Increasing physical gold holdings is a possible hedge. The fixed-income/equity ratio should be adjusted so as to minimize risk. Fixed-income securities usually offer better protection, but high yield junk bonds of highly leveraged companies should be sold and converted to cash. Lower-quality bonds should be sold and replaced with bonds with better ratings. As for equities, sell high and stay with steady blue chips and crisis-resistant companies. The proportion of cash in the portfolio can be increased, as cash is resistant to a downturn. The important point is to decrease risk at the end of a cycle, when stocks are very expensive and the prospects of further advances in the market are diminished.
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.