Preparing Stock Players for a Recession

Okay, let's say the economic bears are right, the economy goes into a deeper than expected slide, and we get slammed with a nasty recession. What then for the country's roughly 80 million stock players? What kind of market losses might they expect, and what would be the smartest portfolio strategy to pursue?

In an intriguing research exercise, the chief investment strategist of Standard & Poor's, Sam Stovall, has taken a probing look at what happened to the stock market during the last 11 recessions, dating back to 1945, and offers up some telling disclosures. For starters, recessions, as you might expect, can be devastating to the stock market, with the S&P 500 in one instance — between March and November 2001 — falling more than 49%.

With recession forecasts continuing to swell, such an exercise is especially topical at this juncture. For example, a former Federal Reserve chief, Alan Greenspan, recently added his two cents to the debate, asserting, "the probabilities of a recession have moved up to 50%." An economist at Morgan Stanley, Richard Berner, has also served up bum tidings, warning, "A mild recession is now likely, with no growth for the year ahead."

Recessions, defined by two consecutive quarterly declines in the gross national product, have occurred, on average, about every 5 1/2 years in the post-World War II period. Overall, they run from six to 16 months, with the average lasting 10 months. With the current economic expansion about six years old, the unmistakable recession message may be overdue. The average loss to equity prices during recessions, as measured by the S&P 500, was 26%, according to Mr. Stovall, with the declines ranging from as little as 7% to a high of 49.1%.

If you think you can escape a recession by investing in those hot overseas markets, forget it. Because of America's influence on the global markets, recession periods have also led to an average 23% decline internationally, as reflected in the MSCI-EAFE index, a benchmark of large multinational companies in developed nations.

In America, there are few places to hide during recessions, Mr. Stovall says, what with all 10 sectors of the S&P 500 posting declines during these periods. The smallest drops were recorded by traditionally defensive sectors: consumer staples, health care, and utilities. The worst performers were industrials, materials, consumer discretionary, and energy. Only three groups turned in positive returns during recession periods: tobacco, household products, and alcoholic beverages.

Which stocks represent the best recession fighters? Among S&P's top defensive picks are eight companies with five-star S&P ratings that are pegged as potential 20% to 35% gainers over the next 12 months. The companies, with health care in the forefront and their projected percentage gains in parentheses, are Mindray Medical International (35%), Thermo Fisher Scientific (34%), Bristol-Myers Squibb (31%), Psychiatric Solutions (30%), Laboratory Corp. of America (23%), Schering-Plough (23%), Aetna (21%), CVS Caremark (20%), and Icon (20%). For investors fearful of a recession, S&P thinks they could increase their portfolio exposure to exchange-traded funds that emulate the performance of traditionally defensive sectors. These ETFs are Select Sector SPDR-Consumer Staples, which trades under the symbol XLP, Select Sector SPDRHealth Care (XLV), and Select Sector SPDR-Utilities (XLU).

Interestingly, while S&P sees economic weakness ahead, it doesn't expect a recession, although it hasn't ruled one out. On a numbers basis, it looks for real growth in the gross domestic product to decline from the 4.9% pace recorded in this year's third quarter. It sees a 0.6% growth rate in the first quarter of 2008, bookended by 1.4% growth in the current quarter and a 1.5% advance in the second quarter of 2008.

S&P's chief economist, David Wyss, thinks that at least one quarter of a decline in real GDP is a possibility, and he has therefore elevated his recession-risk estimate to 40% from 33%.

Generally, recession forecasters attribute such expectations to slowing growth in consumer spending in 2008. Mr. Wyss also thinks the same way, but he believes consumer spending may not evaporate as much as anticipated, given continued strength in unemployment. Further, he thinks the economy should get a boost from a 10% gain in 2008 exports. What about the surging price of oil, which many economists view as a significant contributor to a slowing economy? Despite the concerns, Mr. Wyss notes that rising oil prices have not yet forced consumers to cut back on their spending. "Energy isn't as big a deal as it used to be, and we'll gradually get used to the higher price level," he says.

While a number of major brokerage firms have lowered their oil price expectations for 2008, some to the $55- to $70-a-barrel range, S&P has gone the other way, recently boosting its forecast for next year to an average price of $85.

Explaining it, Mr. Wyss says, "We think higher oil prices are more the result of strong demand, rather than a rising risk of supply disruption."

dandordan@aol.com