Strategies to Ride Out a Recession--or Worse

Now that a recession has almost certainly arrived, the next question is: How bad will it get? Opinions vary, and so do your options as a mutual fund investor.

The conventional outlook calls for a modest slowdown, followed by a recovery several months hence. Depending on whom you talk to, either stock funds or higher-quality bond portfolios would do well under this scenario.

A minority viewpoint sees the economy getting much worse, perhaps even skidding into a 1930s-style depression. In this case, bond or money market funds that hold Treasury securities would probably be your best bet.

It’s this third scenario that most worries Don Evans of Evans, Brinkerhof & Nelson, a money management firm in South Laguna Beach. “We feel an economic storm is coming, and we want to be out of the way,” he says.

Evans subscribes to the “Kondratieff wave” theory, an idea put forth by a Soviet economist decades ago that predicts major economic busts every 60 years or so. Evans sees parallels between now and the 1920s in areas such as Third World indebtedness, farm bankruptcies and corporate buyouts.

He’s especially worried about the high levels of debt throughout the global economy. Evans suspects that people could become so wary of borrowing that they wouldn’t do so even if the Federal Reserve continues to lower interest rates--a scenario that would hinder the government’s ability to stimulate the economy. He predicts a prolonged, painful bout of deflation--a condition hardly felt in this country since the ‘30s--and a stock market crash that could take the Dow Jones industrial index down to between 1,500 and 1,700, maybe lower.

To prepare for all this, Evans recommends only Treasury bills or money market funds that hold them.

John Dessauer, publisher of Dessauer’s Journal of Financial Markets, a newsletter based in Orleans, Mass., scoffs at such predictions of deflation and depression. The key difference between now and the late ‘20s, he says, is that our understanding of how to manage economic problems has become much better.

Between 1929 and 1932, Dessauer says, the nation’s money supply contracted by more than 32%--a factor that made the Depression worse. By the late ‘30s, the Federal Reserve had reversed this policy, and economic growth picked up. “The lesson of the 1930s is that governments can counter the downward pull of a severe economic crisis by expanding the money supply,” he argues.

And in recent weeks, the Federal Reserve has started to do just that, Dessauer says. This leads him to believe that the nation is roughly halfway through the current recession. He recommends buying stocks or stock funds now because the market will likely rise before the economy does, in anticipation of a recovery. “You have to buy stocks before things improve to get the big gains.”

The real long-term danger, Dessauer says, is not deflation but accelerating inflation, although he doesn’t see that happening anytime soon. Rather, he forecasts moderate inflation for the near term--a prognosis that bolsters his pro-equity stance since stocks have historically fared well in a mildly inflationary environment.

But to guard against the possibility of either double-digit inflation or some type of economic or political crisis, Dessauer recommends keeping a small portion of your portfolio in precious metals--bullion, gold mining stocks or gold mutual funds.

Esther Berger, a vice president at Paine Webber in Beverly Hills, offers yet another outlook. She believes that we’re in the early stages of a recession and expects both inflation and interest rates to come down in the months ahead. The best way to profit from this, she says, is to invest in bonds or bond mutual funds. The bond market has been rallying since late September on signs of a slowing economy. She sees more interest rate cuts in store.

While falling rates would tend to boost the value of bond investments in general, Berger suggests sticking with top-quality holdings. Since a weakening economy could increase the number of bankruptcies, she sees no reason to stray from Treasury bonds, highly rated municipal bonds or debt issued by U.S. government agencies--as well as mutual funds that specialize in these areas. “The yield spread (on lower-rated bonds) might be wide, but it’s not worth the risk,” she says.

Notably, Berger recommends longer-term bonds and bond funds because their prices can be expected to rise most dramatically if rates continue to head lower. She advises against keeping assets tied up in money market funds or bank CDs, since their yields will decline as interest rates fall. Besides, these vehicles don’t offer any capital gains potential, unlike bonds and bond funds.

Just to be safe, Berger recommends maintaining some exposure to a traditional, long-term inflation hedge, such as real estate, precious metals or stocks. “Economics is an inexact science,” she points out. “You can never be exactly sure what will happen.”

That’s the thinking behind asset allocation mutual funds, which take hedging to an extreme by holding several types of investments at the same time.

For example, the Blanchard Strategic Growth Fund of New York has its portfolio spread among bonds, U.S. stocks, foreign equities, cash and precious metals. By holding a mixture of assets that won’t all rise and fall together, the fund is shooting for consistent gains while hoping to avoid any severe losses.

“We see six to nine months more of recession, with inflation under control,” says Michael Freedman, the fund’s president. “We don’t feel inflation is a big risk, nor do we expect a deep recession.” With that in mind, Blanchard Strategic Growth has its largest position in bonds, at 35% of assets, followed by foreign stocks (25%), U.S. equities (20%), cash (10%) and precious metals (10%).

In short, with the economy heading into recession, nobody knows how bad it might get. You can protect against stock market crashes and economic catastrophes by parking your cash in money market funds. You can capitalize on deflationary pressures by investing in top-quality bond funds, whose prices rise as interest rates fall.

If you don’t think the current slump will be severe or simply don’t know what’s in store, a good bet is to maintain a well-rounded portfolio that includes at least a small holding in stocks or stock funds. Over time, inflation, not deflation, has been the norm, and stocks, not bonds, have been the investment of choice. And there’s no better time to invest in equities than at the bottom of a recession.

THE ULTIMATE DEFLATION HEDGE

In a deflationary environment, with interest rates falling, bond prices in general would rally. However, long-term zero-coupon Treasury bonds could make especially good investments. Here’s why:

Zero-coupon bonds don’t pay current interest. Instead, they’re sold at a discount to their par value and gradually appreciate to that price by the time they mature. Because zeros don’t pay interest, buyers lock in a yield that becomes increasingly appealing when interest rates fall. That’s why zeros tend to appreciate more than other bonds in this circumstance. By the same token, zeros get hit harder by rising interest rates. On longer-term zeros, these price fluctuations are more extreme. Only if you plan to hold to maturity can you ignore this volatility.

One key advantage of Treasury zeros is that they’re backed by the federal government, which is unlikely to default even in a depression. And unlike other types of bonds, Treasury securities generally can’t be “called,” or redeemed prior to maturity at the issuer’s option.

You can buy individual Treasury zeros through a broker. Benham Capital Management (800-472-3389) and Scudder, Stevens & Clark (800-225-2470) offer no-load zero-coupon Treasury bond funds. Either way, you get some deflation protection.

The following chart, prepared by Benham, estimates how a change in interest rates would affect various Treasury securities:

Change in value if Change in value if interest rates rise interest rates fall Security 1 percentage point: 1 percentage point: 1-year T-bill -0.9% +0.9% 5-year T-note -3.8% +4.0% 10-year T-note -6.2% +6.7% 30-year T-bond -9.4% +11.2% 30-year zero T-bond -19.9% +26.7%