Making Money in a Recession

Despite not agreeing exactly when will the next recession hit, most economists agree that it isn’t far in the future. The longest Bull Market is coming to an end, so investors should transform their portfolios to gain or reduce losses during the next economic downturn. The options are diverse, and we tried to narrow them down to the most common and effective.

Short selling

Everybody has heard of the renowned movie Big Short and how rich Michael Burry and Steve Eisman (known in the movie as Mark Baum) got, but few understand what a short sale is.


Michael Burry: The genius behind the Big Short Source: CNBC
Michael Burry: The genius behind the Big Short Source: CNBC

This investment mechanism consists in selling an asset or stock that the investor doesn’t own. Anticipating a price decline, an investor sells the previously borrowed securities having to return the same number at a later date, meaning that he intends to sell when the price is high and buy back when the securities are cheaper. The lender of the securities is the broker-dealer that the investor relies on to place a sell order. This trade is made on the margin and is leveraged, meaning an investor can make much more money than the amount of the securities, but it also represents a risk if the price increases instead of declining. This type of investment requires that 150% of the value of the securities stays in an account.

Due to its risks and margin requirements, short selling is not adequate for amateur investors or small investors due to its raised expenses: costs of borrowing the security to sell, the interest payable on the margin account that holds it, and  high trading commissions.

In times of recession, short selling poses high returns, particularly for experienced investors that predict Bear Markets before they happen. Overpriced securities are the most targeted by short sales since they fall the most in an economic downturn.

Gold

Gold has been perceived has a safe haven investment for hundreds or even thousands of years, especially in times of uncertainty in the financial markets similar to the ones we live today.

Historically it has always been used as a physical store of value due to its rarity and traded back and forth to protect value in times of war, recession, political turmoil, etc. Since gold cannot be printed and its price is resistant to changes in interest rates, gold has tended to maintain its value throughout time.

When we compare it with stock indexes (S&P 500 or Dow Jones Industrial Average), it is evident that the price of gold has continuously increased, but with much lower variations. Another aspect that stands out is the negative correlation between stocks and gold notably in times of recession: in the Dot Com Bubble in the 2000’s and in the Subprime Crisis of 2008, investors withdrew their money from stocks and stockpiled it in gold and gold derivatives. This last statement can be verified in the graph when the stock market takes a dip, gold prices raised especially before and during periods of recession. 

But how do we invest in gold? The easiest way is to buy physical gold or goods made using this rare mineral, like jewellery or coins, in the private market. But the amount we can buy this way is very limited and may not be correctly priced. Therefore, to bet on the variation of gold’s price or of other physical commodity in the public market, an investor can buy/sell Gold Futures, ETFs, Mutual Funds or stocks belonging to Gold Companies.

Even during bull markets, gold-related assets are essential in a well-diversified portfolio to guarantee stability and steady returns.


Variation in Dow Jones Industrial Average (Blue) and Gold’s Price (Orange) Source: Macrotrends
Variation in Dow Jones Industrial Average (Blue) and Gold’s Price (Orange) Source: Macrotrends

What are consumer staples?

Consumer Staples are everyday used products by households that will continue to be used regardless of their cost or the state of the economy. These types of products are unlikely to be cut from any individual budget as the consumer is unable or unwilling to do so. The level of demand on these products tends to be rather constant. Consumer staples go from foods, beverages and drugs to basic household goods like hygiene products.

These type of good are less volatile during economic cycles (non-cyclical) due to its high demand and level of utility, revealing its constant level of demand. Hence, sales and earnings growth in the consumer staples sector tend to remain constant both in good and bad times. Price elasticity of demand is very low, as the demand in this type of product doesn’t react much from changes in the prices of these goods.

What are utility stocks?

Well, utility stocks are stocks related to firms in the Utility sector, a sector in which companies provide basic amenities such as gas, water, electricity or even renewable energies. Investors often include these types of stocks in their portfolio due to their relative stability. Thus, like consumer staples, these utility goods are less volatile during economic turmoil due to their necessity and utility provided.

Utilities are often associated with stable and consistent dividends and the betas of these type of companies are usually less than 1 due to their ability to be less volatile than the equity markets. Hence, during economic slowdowns or even recessionary times of the economy, utilities tend to perform well under these hard circumstances. However, in the opposite case of an expansionary period, utilities might be stocks that will underperform the average. Not only because of the beta’s value but also because utility companies usually have high levels of debt (due to infrastructure needs) and during economic improvements, interest rates increase and investors are able to find better yielding in other alternatives such as Treasury bills. Therefore, utilities perform well under economic slowdowns since interest rates decrease and the yield related to utility stocks is greater than the risk-free assets.

What are healthcare stocks?

Healthcare stocks are stocks in this case related to firms in the Healthcare Sector which consists of businesses that provide medical services, manufacture medical equipment or drugs and/or provide medical insurance to patients. In the U.S., the healthcare sector is one of the largest accounting for one fifth of the total annual GDP. Healthcare services are associated with highly price inelastic meaning changes in prices have a little effect have on the quantity demanded.

Holding an all-stock portfolio such as the S&P 500 index fund can be improved by simply adding a value-weighted healthcare portfolio, resulting in both a higher return and a lower standard deviation (diversification-effect). Healthcare stocks were the strongest performer in this index in 2018. However, this sector is becoming more volatile with the slowing of corporate earnings, trade wars and rising interest rates.

ETF

An Exchange-trade fund is a security made of a basket of different securities combined in a single entity, which then gets traded like an ordinary stock in the major stock exchange markets.

The ETFs generally can track an infinite range of benchmarks, from commodities to every possible stock, with the purpose of getting has much return has possible in all the different segments of the markets chosen. They are most usually focused on the same type of security and so they can be characterized as Stock, Bond or Commodity ETFs. 

To invest in an ETF, you first need to choose the benchmarks you are willing to risk your money on as the economies they’re in, while also bearing in mind the proportion each company takes on that ETF.

ETFs have its pros and cons which, on the good side, offer horizontal diversification of securities and transparency, since with the help of the internet we can see its true value based on what’s inside of it, but on the other side you have trading costs related with expense ratios and commissions to brokers and the fact that very specific ETFs may not have high demand levels, making it harder to sell it in the short-run and so, less liquid.

Some of the most well-known can be the SPDR S&P 500 ETF that replicates the famous S&P 500 index, which is the general overlook of the biggest 500 public companies in the world, the SPDR Dow Jones Industrial Average ETF and the Invesco QQQ, which also track the Dow Jones and the Nasdaq-100 indexes, respectively, both providing the industrial and technological overlook of the US economy. These three ETFs have positive correlations with the evolution of most relevant global economies and so, they deal with a great variety of market segments, making you invest not in any particular benchmark but in an economy, which is not the case for the majority of them.

REITS

A real estate investment trust (REIT) is a corporation that owns and manage income-producing properties

They can be characterized in three different ways, them being:

  • Equity REITS

It is the most common one, which owns and manages real estate directly, being the revenues from the leasing and rents of tenants the primarily form of income and not the reselling of portfolio.

  • Mortgage REITS

It is mainly focused on financing real estate and the revenues are generally made by what’s earned from the interests of those mortgage loans. Also, they invest in and own residential and commercial mortgage-backed securities for their portfolios.

  • Hybrid REITS

It performs both equity and mortgage operations.

REITS can either publicly traded or private whilst the traded ones provide more liquidity to the investor than the private ones.

Investing in REITS may have its risks and most of them are directly related with the real estate current market: if property assets start to lose value, their investor will be harmed with that.; the volatility of interest rates, given that a decline in them will consequently give an opportunity to decline as well the assets rate of return; and the fact that real estate isn’t a liquid asset; However, this market shows that real estate tends to appreciate over time. In most cases there are steady flows of income from tenants if the properties are being rented and that in the long-term real estate tend to be quite profitable.

US Treasury Bonds (T-Bonds)

A US Treasury bond (T-bond) is a government debt security that ranges from 10 to 30 years maturity wise and it is known to be one of the safest investments worldwide.

The US Treasury has been around since 1776 and not once has failed to pay its lenders. Also, given that this security is backed by the “Full Faith in Credit“ clause of the United States, it faces a default risk of almost nothing, so, if the main goal to invest is to not lose money, then they are the right security to invest.

However, although being acknowledged as a risk-free asset, there are still some factors that need to be accounted before investing in it.

  • The Opportunity Cost

Considering T-Bonds are evaluated as AAA assets (risk-free), then, that will have an effect on its yields, which will consequently be lower than other potentially profitable assets with higher defaulting risk. The urge to not lose any money may let investors ignoring other safe and with high returns investments.

  • The Inflation Risk

If the T-Bond is not linked with a TIPS (Treasury Inflation-Protected Securities), the inflation risk must be acknowledged by the investor. For example, if the security provides a return of 3% and 5% inflation is occurred, then the investor will come out short since the return is not keeping up with inflation.

  • The Interest Rate Risk


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If the investor hopes to hold the bond until its maturity, then this risk does not need to be accounted. However, if that is not the case, then the investor may have serious problems to liquidate its investment if the Fed decides to increase the interest rates. This happens because, if new bonds are being issued at higher levels of return, then the demand for the original ones will fall causing the price of the bond to follow that same direction.


Martim Leong - Martim Leong Francisco Nunes - Francisco Nunes

João Ribeiro - João Ribeiro

Risk: Are we “Picking up nickles in front of a steamroller?”

When we think about risk usually we do not associate it with biology. “It’s another parameter to consider when making an Investment” – is what we tell ourselves. We tend to perceive risk as an external factor internal to the asset or portfolio we are analysing and not to us. And why is that? Why do we associate risk to an irrational set of things when its existence is solely our making?


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Risk is a very hard concept to define. Some perceive it as being the unpredictability of our returns whilst others are more inclined to defining it as the loss we suffer when we don’t choose the safe bet. Whatever is the real risk definition it surely has lead to absolutely catastrophic situations. Elise Payzan-LeNestour, a behavioral scientist in the field of neurofinance, made an interesting experiment to test whether risk behavior comes from human incapability of perceiving it or human recklessness of taking it either way. In the final stages of her experiment she asked around 400 students to play a game called “The Bowman Game”. The students had to choose between two options: skip – the safe bet – or bet – the risky choice. If they chose to bet, the bowman could hit the mark, and they would win 2$, or miss it, and they would lose 40$. Also, there were two different types of bowmans: a novice – more likely to miss the mark – and an expert – more likely to hit it. After collecting all the experiment data, Elise discovered that students were actually very smart in the understanding whereas their bowman was a novice or an expert.

However, she also concluded that even when the bowman was a novice, 40% of the students took the risk of losing 40$ either way. With this, Elise was able to extrapolate to the financial market and conclude that, even though we are perfectly aware of the risks of choosing to gamble instead of the safe option, “we are greedy and lack self-control” in the sense that we evaluate those risks and still accept them when the perfectly rational choice would be to back away and choose safely.

After this discovery, Elise went deeper and associated our human need for this risky gamble to our brain functions, finding the culprit in Dopamine, a hormone triggered by potential reward opportunities.


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The presence of this greed makes us put our necks on the line without backup plans or emergency exits. Taking these risks can lead to the loss of irreplaceable or non-recoverable resources, not only financially but also environmentally, for example. Our overconfidence on the market that never goes down is lost when it inevitably does and the public money goes down the drain. When we are taking part in an investment and building a continuous flow of renewable income we have to be aware of the notion of risk and of how it is not exterior to us but actually very much correlated to our reasoning and individuality. Joe Wiggins, winner of the Brian Abel-Smith Prize for outstanding performance at MSc in Behavioural Science at the London School of Economics, tells us that when we manage a set of financial assets, the risk lies as much on the asset’s trading market performance as on how frequently we check our portfolio, our individual incentives, our differences and our past experiences, to name a few. The possibility to trade at any given moment in time makes public equity investments more risky than private ones where we are less faced with price fluctuations and so have less emotional reaction. In sum, the risk of making bad decisions is lower since the immediate forces are less known. On investment, Wiggins states, “We can think of this as our erratic perception of risk continually shifting our personal discount rates”.


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Risk goes beyond the convention of possible capital loss, it goes far from being only related to the asset or market characteristics, it lies much more on the human conscious action to ignore the possible (maybe less probable) consequences of losing it all. Behavioral Science & Economics alerts for the need to find tools able to deter investors from taking actions with possible “collapsing economy side-effects” because with risk “surely you will be harmed, you don’t know when, but surely you will”, says Elise Payzan-LeNestour.  Investors shouldn’t continue to be rolled over for picking up nickels.

Sources:

  • Ted Talks

  • Behavioural Investment