By: Dividend Sensei
The most important factor in long-term investing success is being able to ride out the inevitable recession and the bear market that goes with it. I track the real time risk of a recession in my weekly portfolio updates. Right now the risk is low but it’s never too early to start thinking about how you can position yourself against the next downturn. So let’s take a look at what makes for a good recession proof or defensive stock. I’ll also highlight three top undervalued names you can buy today that are likely to outperform the market significantly during the next recession.
What Makes For A Good Recession Stock
Stock sectors go in and out of favor depending on the state of the economy and the interest rate environment. This is because interest rates are mostly set by the bond market which prices US Treasury bonds (rate proxy) based on short and long-term economic growth (and by extension) inflation expectations. For example if the bond market expects very strong growth and rising inflation then we’re said to be in a bear steeping regime. That means long-term (10 year) yields are rising and faster than short-term rates (2 year). This is the best possible environment for stocks. According to Blackrock, the world’s largest asset manager, since 1995 such an environment has resulted in about 22% annual returns.
In contrast if the bond market is expecting slow growth and low inflation then long-term rates will be falling. And if the Federal Reserve is hiking short-term rates (which can itself cause a recession) then the difference between 10 and 2 year yields (yield curve) will be falling. This is called a bull flattening regime. It’s what you’ll likely see before the next recession starts. This is the second worst environment for stocks, though only slightly worse than the bear flattening regime we’re currently in (rising long-term rates, but short-term rates rising faster due to Fed hiking rates). In our current environment: tech, energy, and REITs do best.
But if the Fed keeps hiking rates and 10 year yields (long-term rates) start falling? Then it’s time to get defensive. Defensive stocks are those sectors with reliable sales and cash flow in a recession. These are businesses that provide essential goods and services that people will buy no matter what the economy is doing. They also tend to pay generous, safe, and steadily growing dividends and have lower volatility. This is why they are sought after during a recession. While defensive stocks won’t necessarily not fall during a bear market, they’ll fall a lot less helping you sleep better at night and avoid panic selling at the worst possible time.
The top three defensive sectors (for an active recession) are: consumer staples, healthcare, and utilities. They generally generate annual total returns of about: 3%, 1.5% and -9%, respectively. That’s not great but remember that during a recession the stock market usually falls 20% to 30%. And during a crash (like the last two recessions) stocks can fall 50% or more. So owning anything that holds up that well can be a huge boon to your portfolio’s long-term returns (by preserving capital).
Here are my top three choices for investors looking to get more defensive. Each of these companies offers: generous, safe, and steadily growing income, low volatility, and is the quintessential sleep well at night (SWAN) stock. They are also likely to beat the market over the next decade.