A sharp decline in the stock market is often an indicator of an impending recession – that is, a temporary period of economic decline. With the S&P 500 Index falling 1,000 points, or about one-fifth, from January through June, a consensus is emerging that a recession is coming, perhaps next year.
Recessions have wildly varying durations and depths. The official judge is the National Bureau of Economic Research, which counts nine of them since 1960, lasting an average of about a year. Recent recessions have been the result of severe shocks to the system: the 2008 financial crisis and the 2020 pandemic. The COVID recession was the shortest in history (two months) but the most intense (gross domestic product down by nearly one-third).
A 2022 or 2023 recession will be very different. If it happens, it will follow a more traditional pattern, triggered by the Federal Reserve Board raising interest rates sharply as a way to reduce consumer and business demand to tame inflation. For investors, there are three important facts about recessions:
- They are uncertain. The Fed raised rates nine times from late 2015 to late 2018 without triggering a recession. Nobel Prize-winning economist Paul Samuelson once famously quipped that the stock market had predicted nine of the last five recessions. Economists have a poor record, too, though two-thirds of them, including Samuelson's nephew Larry Summers, expect one next year.
- They end. This is a critical point for long-term investors, who should keep buying stocks on a regular basis. Using a process called dollar-cost averaging, you can invest a set amount at regular intervals – when stocks are cheaper, you can afford more shares.
- They deliver opportunities. Finally, there is little shelter in the stock market from recessions, but at the same time, they offer remarkable opportunities.
If you have a reasonably diversified stock portfolio, it has likely lost roughly 20% of its value during the first six months of the year. Those losses anticipate a recession – or at least a very rough patch for businesses. The hit has been felt across the board, with the exception of the energy sector, which has benefited from oil and gas shortages caused by the war in Ukraine and the spike in demand as the pandemic economy reopened.
Healthcare, consumer staples and utilities – that is, things that consumers can't do without, even in a recession – have fallen the least, on average about half as much as the rest of the market. These are the classic sectors for safety.
If you are worried about a deep and prolonged recession, consider stocks such as Merck (MRK (opens in new tab)), the pharmaceutical giant. Merck shares are actually up this year, and analysts see profits holding steady through 2023. The stock carries a price-earnings ratio, based on estimated earnings for the year ahead, of 13 and yields 3.0%. (Stocks and funds I like are in bold; prices and other data are as of July 8.)
Another strong healthcare company to consider is AbbVie (ABBV (opens in new tab)), whose products include Botox (a wrinkle-remover and migraine medicine) and Humira, the autoimmune injectable that was the top-selling drug last year after Pfizer's (PFE (opens in new tab)) COVID-19 vaccine. Humira's primary patent will soon expire, and analysts foresee a decline in profits for AbbVie next year; the stock trades at a P/E of just 11. Shares are up so far in 2022; they have a current yield of 3.7%.
During a recession, dividends are especially important because they give you a cushion even if the stock price falls. Also, stocks like Merck and AbbVie, with reliable, high payouts, provide good competition for the bonds to which many investors flee in tough times. Merck's yield tops that of a 10-year Treasury.
Fund investors can consider T. Rowe Price Dividend Growth (PRDGX (opens in new tab)), which invests primarily in firms with a track record of increasing quarterly payouts. A top holding is another healthcare stock, UnitedHealth Group (UNH (opens in new tab)), the nation's largest health insurer. United is down for the year but has still vastly outperformed the market.
The Price fund's only drawback is that its portfolio is larded with stocks whose dividends may be growing but are tiny, including Apple (AAPL (opens in new tab)), yielding 0.6%. The Vanguard High Dividend Yield Index Fund (VYM (opens in new tab)), by contrast, is an exchange-traded fund that stresses elevated dividends paid by strong companies, including drug companies such as Johnson & Johnson (JNJ (opens in new tab)), yielding 2.5%, and Bristol-Myers Squibb (BMY (opens in new tab)), with a P/E of just 10 and a yield of 2.9%.
The Vanguard fund is overweight with consumer staples stocks. Among them are Procter & Gamble (PG (opens in new tab)), yielding 2.5%. Even in a recession, consumers buy brands such as Pampers, Gillette, Tampax and Oral-B. Other consumer defensive stocks that held up comparatively well in the 2001, 2008 and 2020 recessions are Coca-Cola (KO (opens in new tab)), yielding 2.8%, and Walmart (WMT (opens in new tab)), yielding 1.8%. A good ETF in this sector is the iShares U.S. Consumer Staples (IYK (opens in new tab)), which yields 2.1% and was down only 1.4%, including dividends, for the year-to-date. The fund holds Mondelez International (MDLZ (opens in new tab)), whose brands include Oreo cookies and Tang breakfast drink. Mondelez, which dipped modestly in the 2020 recession, yields 2.2%.
The other category that has withstood the 2022 market downturn is more troublesome: utilities. These companies are heavy borrowers. Many also rely heavily on natural gas, whose price has quintupled over the past two years. Regulated large utilities can buffer these higher costs through mandated rate increases, but I still worry about their exposure.
Don't Overlook the Stock Deals
Now for the opportunity. Technology has taken the hardest pre-recession hit. My theory is that these stocks are already priced for a serious recession and may bottom out before the rest. And they are modern versions of consumer-staples stocks.
Take Netflix (NFLX (opens in new tab)). It's down by more than two-thirds this year and trades at a P/E of 17. A basic Netflix subscription is just $10 a year. Yes, the company has competition, but it is preeminent in a field that is unlikely to suffer – and might actually thrive – as the going gets tough. Amazon.com (AMZN (opens in new tab)) is the quintessential 2022 staples stock, yet it’s down nearly one-third this year. Amazon’s cloud-computing business would seem impervious to recession as well. Meta Platforms (META (opens in new tab)) has declined by nearly half. It provides loads of free entertainment with Facebook and Instagram. With most of its revenues coming from advertising, it has more exposure to a recession, but its P/E is just 14, even though the analysts see sales growing 16% next year.
Will there be a recession? I have no idea. What is certain is that parts of the market are priced as if there will be a bad one. My recommendation, then, is for investors to strive for a balance between traditional defensive stocks and exceptional growth companies that have taken a big hit.
James K. Glassman chairs Glassman Advisory, a public-affairs consulting firm. He does not write about his clients. Of the stocks mentioned here, he owns Netflix and Amazon.com. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence. You can reach him at James_Glassman@kiplinger.com.