Weakening job growth provides further support for focusing more on capital preservation than capital accumulation. 

While the next recession may be the subject of talk around the watercooler and at cocktail parties, you don’t have to know when the next recession will occur.  What you do need to know is that economic growth is already weakening.  Why?  Because slowing economic growth will place downward pressure on corporate profits, a key ingredient in stock valuations.  It can also create a negative feedback loop in which slowing economic growth leads companies to pullback on investing (which they already have) and eventually hiring leading to further slowing of economic growth and the cycle continues downward.

At some point, stock market investors will no longer be able to ignore slowing economic growth and corporate profits.  When that happens, stock prices will fall and unlike periods over the last couple years when stock prices fell and rebounded, at some point they won’t immediately rebound.  This will not only negatively impact stock portfolios; it will negatively impact consumer confidence and spending.  A pullback in consumer spending, if severe enough will lead to a recession.  Why?  Because consumer spending is the primary driver of economic growth today as business investment and trade are detracting from economic growth. 

INVESTMENT STRATEGY APPLICATION

These facts indicate the following as a prudent investment strategy:

Maintain a diversified portfolio with a clear defensive positioning

Maintain a portfolio that will do better in a slowing economic environment.  Said another way, maintain a portfolio that is less vulnerable to the negative impacts a slowing economy will have on the stock market and the ability of less financially strong companies’ ability to make their monthly interest payments.

              How?

  1. Reduce your allocation to stocks below your long-term target allocation 

For example, if your long-term allocation is 50% stocks, reduce to something less.  How much less depends on the following:

  1. How willing are you to possibly lose 10% to 20% in your stock portfolio AND have it remain down for a few years? 
  • Looking at it from the opposite perspective, how willing are you to miss out on the opportunity to buy stocks at 10% to 20% less than they are today?
  • When do you need to cash out your stocks?  The sooner you need to cash out your stocks the more you want to lower your allocation to stocks.
  • For your stock allocation, focus on:
  1. Stocks that are less dependent on economic growth or said another way, less impacted by slowing economic growth

These are often called Consumer Staples.  They make the goods people use every day.  Recession or not, people will need to eat, drink bathe, and brush their teeth. 

Companies that make or serve food are generally less dependent on economic growth.  During a recession you may cut back on eating ut, but you will still need to get your food somewhere.  Maybe it means buying prepared foods instead or cutting back on prepared foods, but you will still need to eat. 

Companies that make personal care products such as toothpaste, dental floss, shampoo, and deodorant are also less dependent on economic growth. 

  • Stocks with higher dividend yields

Today’s slowing economic growth and low yield environment make stocks with higher dividend yields attractive.  Higher dividend yielding stocks are generally less susceptible to the negative effects of slowing economic growth and, if you are going to be exposed to the volatility of the stock market, at least get a higher dividend yield. 

Consumer Staples, because of their lower growth prospects, often have higher dividend yields and as  result they not only offer lower sensitivity to slowing economic, they offer higher dividend yields.

Utilities also offer higher dividend yields.

  • Fortress balance sheets

When economic times get tough, slumping sales can lead to companies having challenges in paying their bills and making payments on their debt.

Companies with greater cash on hand and access to financing, will generally better weather economic downturns.  In a slowing economy, a strong balance sheet having adequate cash reserves and lower debt can provide a bulwark against slowing economic growth.  These companies are sometimes referred to as “blue chip” stocks or “large cap” stocks.  They are generally larger companies, typically found in the Dow Jones Industrial index or S & P 500 index.  Smaller stocks that would likely be more challenged during an economic downturn and reduced sales would be companies found in the Russell 2000. 

Note:  Not all large companies have strong balance sheets.  Some are heavily indebted. If you are going to choose individual stocks as opposed to an index or basket of stocks. evaluate each company’s balance sheet and importantly, access to financing.

  • For your fixed income allocation:
  1. Fortress balance sheets

Similar to when evaluating stocks, seek out bonds from companies with strong balance sheets.  This means companies that can safely meet their debt service obligations, have ample cash to supplement interim periods of slumps in cash flow, and access to additional financing to provide additional short-term financing to supplement lower cash flows when cash reserves are inadequate.  These companies typically have investment grade bond ratings.

Note: There can be meaningful variation in company balance sheets even among investment grade companies.  A meaningful economic slump and slowdown in sales would push some lower quality investment grade companies into non-investment grade status.  The lowest investment grade rating for S & P and Fitch is BBB- and Baa3 for Moody’s.

  • Fortress cash flows

When investing in fixed income, you don’t get paid more when company cash flow increases.  So, focus more on the companies having fortress cash flows.  These are companies that have steady, reliable income streams.  These can be less economically dependent companies like Consumer Staples.  They can also be utilities.  They can also be companies with a subscription service.  It can also be companies with what they call high switching costs.  Switching costs are the costs associated with switching from one product to another.  For example, switching from a Mac operating system to a PC operating system is expensive from the time involved alone.