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Finding the best stocks for a recession
Do you want to pick stocks that hold up in a recession and avoid the ones that don’t? Here’s what you can do as an investor to make sure your portfolio is ready.
Big ideas
- Certain types of stocks tend to be more resistant to recessions. Allocating more to these stocks when the economy is weak can help protect your portfolio.
- For the stock market, a recession is usually bad news. However, most investors are not best served by selling everything but by fine-tuning their investment approach.
- Defensive stocks should be favoured over cyclical stocks, and putting a greater emphasis on dividends over growth usually makes sense during a recession.
If a recession is either here or highly likely in the near future, what can you do as an investor to make sure your portfolio is ready? How should you pick stocks today if you are worried about a recession arriving soon? The key is to invest in 'recession stocks' from sectors that have historically been more resistant to economic downturns.
What happens to the stock market during a recession?
First things first, if a recession is expected, then all stock valuations may be vulnerable in the near future. This means that, on average, stock prices today may be higher than they would be in a recession, so caution is required.
The following chart shows how stocks, bonds and cash will usually fare during different stages of the economic cycle. Clearly during a recession is the worst time to own stocks.
The following chart shows how stocks, bonds and cash will usually fare during different stages of the economic cycle. Clearly during a recession is the worst time to own stocks.
Average annual absolute return
This does not mean selling everything and building up your so-called ‘dry powder’ ready to go to battle in a future strong economy. It also doesn’t mean you should stop managing your portfolio and put your head in the sand. This approach would be foolhardy in an environment where some types of companies and some sectors can be expected to hold up better than others.
Aspects such as dividends, market position and economic sector can provide avenues for investors to make their portfolios ready for any outcome, even a severe recession.
What type of stock will probably fare better than average if a recession hits? To answer this question, we need to look first at the difference between cyclical and defensive stocks.
Aspects such as dividends, market position and economic sector can provide avenues for investors to make their portfolios ready for any outcome, even a severe recession.
What type of stock will probably fare better than average if a recession hits? To answer this question, we need to look first at the difference between cyclical and defensive stocks.
Recession-proof stocks (buy defensive, sell cyclical)
Cyclical stocks are those which tend to follow the rhythms of the business cycle very closely. This means that they will perform very well when GDP is rising and can be expected to falter and go into reverse when economic conditions worsen. As such, their valuation tends to follow and be determined more by the business cycle than other variables.
Typical cyclical stocks include car manufacturers and airlines. In general, fewer people will purchase a new car when the economy is in or is close to a recession, and likewise, consumers will tend to cut things like holidays which are perceived to be non-essential or luxury purchases if they have some doubts about the health of the economy moving forward.
In the following chart, you can see that when the covid-19 recession of 2020 hit, these three cyclical stocks lost around 50% of their value, underperforming the S&P 500 index, which fell 34%.
Typical cyclical stocks include car manufacturers and airlines. In general, fewer people will purchase a new car when the economy is in or is close to a recession, and likewise, consumers will tend to cut things like holidays which are perceived to be non-essential or luxury purchases if they have some doubts about the health of the economy moving forward.
In the following chart, you can see that when the covid-19 recession of 2020 hit, these three cyclical stocks lost around 50% of their value, underperforming the S&P 500 index, which fell 34%.
Source: TradingView. Past performance doesn’t guarantee future results.A subcategory of cyclical stocks is ‘consumer discretionary’ stocks because the type of consumer spending that generates revenue for these companies is discretionary and non-essential in nature.
Buying stocks during a recession can be more challenging because overall company earnings won't be as high. An investor anticipating a recession may be less inclined to buy consumer discretionary stocks since consumer incomes are likely to drop, leading to reduced spending on non-essential items. This expected fall in revenue for cyclical companies is typically reflected in lower share prices.
Buying stocks during a recession can be more challenging because overall company earnings won't be as high. An investor anticipating a recession may be less inclined to buy consumer discretionary stocks since consumer incomes are likely to drop, leading to reduced spending on non-essential items. This expected fall in revenue for cyclical companies is typically reflected in lower share prices.
Recession-proof industries: Defensive stocks
Defensive stocks will usually keep performing acceptably, regardless of the overall economic climate. As such, whilst their value may fall a little during a recession, they will hold their value much better than cyclical stocks over the same period. Similarly, defensive stocks tend to be better at paying dividends, even during times of economic distress. This is because consistent earnings generally enable a conservative dividend policy.
Classic examples of defensive stocks are:
Classic examples of defensive stocks are:
- Utilities
- Consumer staples
- Healthcare
- ‘Sin stocks’ such as tobacco and alcohol
Even in the worst recession, smokers will tend to prioritise buying cigarettes or e-cigs and try to make savings elsewhere. Likewise, companies that provide energy or water will be very likely to keep their customers because their services are essential.
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Dividend stocks as evergreen investments
Stocks that have a proven track record of paying out dividends to their shareholders are attractive in any phase of the business cycle. For this reason, they can be thought of as ‘evergreen’ investments that are always useful to have in your portfolio.
Dividend stocks have over time been some of the best recession proof stocks because when share prices are falling, investors can make a return through the dividend. Remember, there are two main ways to make money buying stocks:
Dividend stocks have over time been some of the best recession proof stocks because when share prices are falling, investors can make a return through the dividend. Remember, there are two main ways to make money buying stocks:
- When the share prices go up
- By earning a dividend
If you are earning a reasonable dividend income from your portfolio of shares, then you don’t need to be as concerned about share prices falling in a recession. Dividends can provide a helpful buffer to any bump your portfolio may take in a difficult economic situation.
If more people are focusing on their dividend earnings during a recession, then naturally there is more demand for those investments and as a result, the share price tends to fall less compared to companies without dividends or less consistent dividend payouts.
To get familiar with dividends, make sure to read our article on Getting Started with Dividend Investing or visit our Dividend Investing category.
If more people are focusing on their dividend earnings during a recession, then naturally there is more demand for those investments and as a result, the share price tends to fall less compared to companies without dividends or less consistent dividend payouts.
To get familiar with dividends, make sure to read our article on Getting Started with Dividend Investing or visit our Dividend Investing category.
Recession in stock markets: Value vs Growth
You might already be familiar with the categorisation of value vs growth stocks. Right before and during a recession, investors tend to opt for value stocks in large part because of their lower valuations. Value stocks should logically have less far to fall in price than their growth rivals with higher valuations.
Recessions can also provide fantastic opportunities to the patient growth stock investor. However, this should only be undertaken if you are happy to take the added risk and accept that you might be sitting on a losing investment for a while until the economy is really back on its feet.
The dot.com boom of the early 2000s saw early enthusiasm for the internet lead to a flood of investment into online companies. As always, the bubble inflated for several years before dramatically popping when the market sobered up and realised not every company with ‘dot com’ in its name would go on to conquer the world and generate massive profits. Over 90% of early online companies went bankrupt following the bursting of the dot.com bubble.
However, several of this generation of growth stocks went on to conquer the world. Amazon, Google, eBay, Microsoft, and others were all classed as risky growth stocks in the early 2000s but anyone who bought into those stocks before the crash and held them until today despite several recessions coming and going has done extremely well.
It’s perfectly fine to find recession-resistant value stocks in defensive sectors, paying dividends to secure your portfolio while at the same time trying to find the next big thing that may never return to such low prices and multiples again.
Recessions can also provide fantastic opportunities to the patient growth stock investor. However, this should only be undertaken if you are happy to take the added risk and accept that you might be sitting on a losing investment for a while until the economy is really back on its feet.
The dot.com boom of the early 2000s saw early enthusiasm for the internet lead to a flood of investment into online companies. As always, the bubble inflated for several years before dramatically popping when the market sobered up and realised not every company with ‘dot com’ in its name would go on to conquer the world and generate massive profits. Over 90% of early online companies went bankrupt following the bursting of the dot.com bubble.
However, several of this generation of growth stocks went on to conquer the world. Amazon, Google, eBay, Microsoft, and others were all classed as risky growth stocks in the early 2000s but anyone who bought into those stocks before the crash and held them until today despite several recessions coming and going has done extremely well.
It’s perfectly fine to find recession-resistant value stocks in defensive sectors, paying dividends to secure your portfolio while at the same time trying to find the next big thing that may never return to such low prices and multiples again.
Recap
A recession means stock prices, on average, will fall, but this won’t affect all sectors and all stocks equally. Look for stocks you like in so-called defensive sectors where prices are likely to fall less than the market average. Recession-resistant stocks are often also those with records of paying steady and ideally increasing dividends over time.
Value stocks will probably hold their value better than growth stocks in the short term if the economy goes into recession. But looking further out, growth stocks may well rebound fast as the recession starts to fade. Recessions can be fantastic times to hunt for bargains – if you can, then buy the dip!
Value stocks will probably hold their value better than growth stocks in the short term if the economy goes into recession. But looking further out, growth stocks may well rebound fast as the recession starts to fade. Recessions can be fantastic times to hunt for bargains – if you can, then buy the dip!
FAQ
Q: What are the best stocks to buy during a recession?
First, there are defensive stocks. These are companies that provide essential goods and services that people continue to need even when the economy is struggling. Utilities, healthcare, and food companies are all examples of defensive stocks. There are also value stocks. These are companies that are trading at a discount to their intrinsic value. Value stocks tend to do well when the market is down, as investors are looking for bargains.
Q: How to recession-proof your portfolio?
You can try to time your investments to take advantage of market cycles. This means investing more heavily in assets that are likely to perform well during a recession, such as defensive stocks, and lessening your exposure to assets that are likely to underperform, such as cyclical stocks. This strategy is not without risk, but if done carefully, it can help to improve your portfolio's performance during a recession.
Q: What is a recession in the stock market?
A recession in the stock market occurs when there is a sustained decrease in stock prices, which is often referred to as a bear market. This can be caused by a number of factors, including a decrease in economic activity, an increase in interest rates, or a change in investor sentiment. A recession can last for a period of months or even years, and can have a significant impact on the economy.
Q: Should you buy stocks during a recession?
On one hand, recessions can offer opportunities to buy stocks at a discount. On the other hand, recessions can be a difficult time to predict the future direction of the stock market. If you are considering buying stocks during a recession, it is important to do your research and understand the risks involved.
- Recession: A period of economic decline characterized by reduced GDP, higher unemployment, and lower consumer spending, often leading to declines in stock market performance.
- Recession-proof stocks: Stocks that tend to hold their value or even perform well during economic downturns, often found in defensive sectors like utilities, consumer staples, and healthcare.
- Dividend Stocks: Stocks that regularly distribute a portion of a company’s earnings to shareholders in the form of dividends.
- Value Stocks: Stocks that trade at a lower price relative to their fundamentals, such as earnings and dividends.
- Growth Stocks: Stocks of companies expected to grow at an above-average rate compared to others in the market, often reinvesting profits instead of paying dividends, and typically more volatile during recessions.
