- The S&P 500 is up 8% year-to-date after a 20% drop in 2022.
- But good luck could end a potential recession on the horizon.
- Bank of America Stocks Where to Invest in a Recession: High Quality; low risk; large lids; small lids; and stocks that generate high free cash flow.
It can be difficult to pinpoint where stocks are in a market cycle – to be able to tell if there’s more downside in a sell-off or if stocks have already hit bottom.
But investing in the stock market doesn’t have to be betting on a single index. Beneath the surface of the market, there are usually bullish opportunities no matter what the S&P 500 is doing.
In a note to clients on Monday, Bank of America strategists highlighted where they see the best opportunities in the current market trends, enlisting the help of their US Regime Indicator. The indicator takes into account factors such as manufacturing activity and sentiment, earnings forecasts and bond yield activity to identify the direction of the economy.
There are four phases of the business cycle: recovery, mid-cycle, late-cycle, and recession. The indicator is now entering its recession phase.
“Our US regime indicator dipped into recession territory this month; if we get a 2na month of confirmation, we are officially out of the Late Cycle and into the abyss,” Savita Subramanian, head of the bank’s US equities, US equities and ESG strategy, said in the Feb. 10 note.
Bank of America economists see a recession coming in the first half of 2023 as the Fed continues on its hawk path and aims to keep rates high through 2023. Many other Wall Street banks also see a recession ahead in 2023, and a New York Fed model focusing on yield curve inversion now puts the probability of a recession at 57%.
Historically, the recession phase has meant that investors generally should look for three types of stocks in particular, the note said: high quality, low riskIt is large cap stocks.
“We found that the behavior of the factors is relatively predictable during different phases of the US Regime Indicator,” added Subramanian. “For example, high quality and large cap tend to outperform during the ‘recession’ phase of the cycle, while value, high risk and small cap tend to outperform during the ‘rebound’ phase.”
During recessionary phases, the three factors listed above outperformed the S&P 500-weighted index by averages between 4.8% and 5.6%.
But Subramanian said he also hopes small cap stocks to overcome this time, given how beaten they already are.
“Small caps typically underperform during downturns/downturns, but the Russell 2000 is already discounting a deep downturn and earnings collapse similar to the GFC, while large caps are expensive compared to history and had an equity risk premium stable,” Subramanian said in a Feb. 1 note, which she referred to again on Monday. “Small caps also outperformed during recessions in the 1970s/early 1980s, when the Fed was keen to tame inflation.”
Furthermore, Subramanian said stocks that generate high cash flow it should also outperform in the current late-cycle environment and downturn phase. High free cash flow is often considered a characteristic of quality inventory.
“As the market cycle matures, companies that continue to generate healthy free cash become scarcer and more sought after,” she said. “Why? Late cycle regimes are usually accompanied by rising costs, wage pressure, rising real rates and increased business investment amidst limited capacity. All of this represents a reduction in cash flow.”
The iShares MSCI USA Quality Factor ETF (QUAL); the Invesco S&P 500 Low Volatility ETF (SPLV); and the Vanguard Large-Cap ETF (VV); and the Vanguard Small-Cap ETF (VB) offer exposure to the above factors.