Time to prepare for a new recession

With the US credit downgrade and continued market turmoil, the odds of another recession keep rising. Take a close look at where your portfolio stands in stocks, funds, bonds and gold.

The risk of another recession in the U.S. is growing, and investors need to adjust their portfolio holdings accordingly.

The downgrade of U.S. Treasury debt late last week only underscores the need to examine the investments you own, why you own them and the risk you're taking. The types and amount of domestic and international stocks in your portfolio, and your opinion of emerging markets, cash and U.S. government bonds -- even the reason for owning gold -- all need to be reassessed in order for your investments to thrive in a challenging, slow- or no-growth environment.

"At this point, it's only a question of whether (a recession) has already begun," said David Rosenberg, the chief economist and strategist at Toronto-based investment manager Gluskin Sheff.

Investors clearly believe they already know the answer, given the punishing sell-off in stocks worldwide over the past several days.


And now that debt-ratings firm Standard & Poor's has stripped the U.S. of its triple-A rating for the first time, dropping it a notch to AA+ out of concern over the U.S. political process, both stock and bond investors have yet another imperative to consider new ways to take advantage of less-forgiving market conditions.

"We are not likely done with this correction, as the factors that triggered this sell-off have yet to be addressed, let alone successfully resolved," said Sam Stovall, the chief investment strategist at Standard & Poor's Equity Research, in a note to clients on Friday.

While another recession within 12 months is more likely -- many observers now put the odds at about one in three -- those who believe the economy will escape this mud-stained "soft patch" without a setback may ultimately be right.

Regardless, it's clear that the investing playbook is changing. Here's what you need to know to stay ahead in the game:

Stock investors realize the U.S. economy has been on a slow track, but until last month the overriding belief was that domestic growth would improve over time.

So when the Federal Reserve's stimulus package known as QE2 stopped at the end of June, investors also knew the frail patient would still need help getting around. The hope was that a robust corporate sector would provide support with capital spending and job creation.

Then the picture darkened. The confidence-sapping debt-ceiling debate, Washington's newfound austerity and economic data that cast doubt about the efficacy of QE2 has stoked fears that recession, not inflation, is the gravest threat to fragile U.S. and global markets.

"What we had was an artificial recovery propped up by deficit spending and monetary stimulus," said Rob Arnott, founder of Research Affiliates, a Newport Beach, Calif.-based investment management firm.

"If the private sector failed to have its animal spirits invigorated by the fiscal and monetary stimulus, then the stimulus failed," he added. "And that puts us back into a recession that never really ran its course."

Such a backdrop isn't conducive to either corporate or consumer spending. Accordingly, risk-averse investors are now focusing on the return of capital more than return on capital. Stock and fund buyers are embracing traditional "recession-proof," dividend-rich sectors such as utilities, health care and consumer staples.

Within those sectors, look for companies that have above-average dividend yields, are flush with cash and sell goods and services that people need regardless of the economy. In the best cases, solid businesses can take advantage of weaker rivals to gain market share and emerge from a downturn even stronger.

"A focus on hybrids or income-equity portfolios that generate a yield far superior than what you can garner in the Treasury market makes perfect sense," Gluskin-Sheff's Rosenberg said in an e-mail.

More sophisticated investors can maximize their return potential by reducing exposure to riskier assets such as small, aggressive growth stocks and adopting a bigger-is-better approach, Rosenberg added.

"Relative-value strategies that can go short low-quality and high-cyclical equities while going long a basket of high-quality and low-cyclical equities will be a moneymaker in this environment," he said.

Mutual funds designed to make money when the market loses are also worth considering as a hedge. Jeffrey Hirsch, the editor-in-chief of the Stock Trader's Almanac, favors two so-called bear-market funds, Grizzly Short Fund (GRZZX) and Federated Prudent Bear Fund (BEARX).

Hirsch said he expects further stock declines: "My number is Dow 10,000," he said, referring to his near-term target for the Dow Jones Industrial Average ($INDU).

"Avoid taking any hasty long positions in individual stocks and the broad market," he added. "You can probably buy anything you want cheaper over the next few months."

Still, with volatility and uncertainty swirling, don't take anything for granted. Investors need to keep an especially close eye on their portfolios, as conditions can change quickly. Health care and consumer staples, for example, are two areas to be a cautious about overweighting, as they tend to lag when the market begins another upward move, said Stuart Freeman, the chief equity strategist at Wells Fargo Advisors.

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