In today’s issue:

  • Investors should get defensive, right now
  • Get out of tech, banks and consumer discretionary sectors
  • Go for diversification and dividends

Yesterday I explained how, given stubbornly high inflation, defensive investors shouldn’t flee into bonds or cash.

They should rotate within the stock market, rather than rotate out.

Today, I’ll highlight stock market sectors to avoid if you want to recession-proof your portfolio.

These are tech, financials, real estate and consumer discretionary.

The key thing to understand is that, in a recession or stagflationary environment, it’s discretionary (non-essential and desirable) rather than non-discretionary (considered necessary) spending that gets squeezed.

Let me explain why…

Households tighten belts and budgets.

Consumers facing a real income squeeze need to save money. Rather than shop around for the best value, as happens with non-discretionary items, with discretionary goods, they might not shop at all.

The world of discretionary goods is also fickle. The trends and fashions that compete for consumers’ incomes come and go.

It’s hard to know from one year to the next which product in which sector will be the “must-have”.

Those firms that can stay one step ahead of consumers’ preferences can be highly profitable. Coca-Cola is an example of a firm that has done well at keeping its products up with the times, if not always ahead.

There are other examples but few with such global scope or longevity.

Tech is the new consumer discretionary

Today, the world of discretionary goods has a huge tech component, especially when viewed in valuation terms. Think Apple and Tesla, two of the trendiest brands in the developed world.

While most consumers no doubt need a smartphone or simple car, not one of them needs an iPhone or Model X. Moreover, even existing Apple or Tesla customers might not be so keen to dip into their inflation-squeezed budgets to upgrade so often.

But the valuations of both firms, and of the “Big Tech” sector as a whole, are historically expensive. By some measures more so than in 1999, before the historic, tech-led bust that followed.

Tech has long been a highly cyclical sector. It’s prone to big declines in recessions. Hence defensive investors should now invest less in tech stocks or just avoid them.

Of course, if you’re inclined to own some Big Tech, Microsoft and Google could be safer options. After all, some of their growth is driven less by consumer discretion and more by the comparatively essential, almost utility-like nature of much of what they provide.

But there are also three other sectors to avoid. Taking 60 years of data and sorting sector by sector, the worst performers in recessions, other than tech, are consumer discretionary, financials and real estate.

Real estate is pointing the way down

Double-digit percentage declines in recessions are the norm for all of the above. Here in the UK, the highly sensitive real estate component of the FTSE 100 declined by some 15% in Q4 last year.

Yet banks rose by 12%.

The UK’s biggest bank by market capitalisation is HSBC (red line on chart below). The biggest REIT is SEGRO PLC (blue line). Look at the divergence in their share prices over the past few months:

Source: Koyfin

This is unusual. My guess is that financials are about to follow real estate lower, perhaps much lower. Consumer discretionary won’t be far behind.

Be selective with industrials and materials

While industrials and materials are both highly cyclical, they tend to be less sensitive to recession than the above sectors. They’re also not homogeneous.

A defence contractor such as BAE Systems is in fact a highly defensive company. It’s not exposed to cyclical swings as most industrial companies are.

Materials companies may be cyclical and their share prices volatile. But it’s worth noting here that commodities are historically undervalued versus the stock market generally.

They are currently trading at historically low, rather than high, valuations. That implies they may have more defensive properties than normal in an economic downturn.

Some also pay generous dividends. The same is true of the big energy companies.

Combined with traditional defensive sectors, owning high-dividend industrials, materials and energy firms help to diversify a recession-proof portfolio. At the same time it provides greater dividend income.

But there’s one more thing defensive investors should do. If you don’t already own precious metals, now is the time to add them to your portfolio.

Precious metals do well in stagflationary conditions such as those facing the UK today.

Tomorrow, I’ll offer some specific thoughts for how to get started investing in precious metals and miners.

Until next time,

John Butler
Investment Director, Fortune & Freedom