Post-recession investing

No matter which kind of economic recovery we get, diversification still wins

Most experts agree that the recession is now over: In the most recent reports by the 12 regional Federal Reserve districts, all but one noted economic improvement. But what lies ahead for investors? The answer depends on whom you ask. Economists and investment professionals describe their forecasts for the direction of the national economy in ways that sound like carnival rides: the Rebound, the Lightning Bolt, the Double Dip.

Fortunately, as long as your portfolio is diversified, your investments are probably going to be in good shape no matter which ride we take. And you won't need to be incredibly precise in your predictions for growth. Clairvoyance isn't important, but diversification is.

Three recoveries, one plan

Although the economic forecasts for the next 12 to 18 months vary greatly, they can be reduced to three essential types, and each has occurred in recent economic history.

Slow growth

Probably the most common expectation among forecasters is for the economy to experience a recovery, but a tepid one, as occurred in 1992. The thesis is that consumer spending, constrained by tightened credit, falling home prices, and high unemployment, is not going to rebound anytime soon. But productivity will remain high as companies return to normal production levels, though they'll employ fewer workers.

Although this forecast doesn't sound very optimistic—and it certainly isn't for some aspects of the economy, such as employment—historically a slow recovery is better for stocks than a rapid upturn. Liz Ann Sonders, Schwab's chief investment strategist, notes that since the 1970s, the Standard & Poor's 500 stock index rose more than 7 percent per year during periods of lukewarm economic recovery, defined as growth in the gross domestic product of no more than 6 percent annually. Although it's counterintuitive, in periods when the GDP grew at a more rapid clip, stocks have actually fallen 4.6 percent.

Sharp rebound

That can occur if the economy suddenly snaps back from the deep recession, which is what happened in the mid-1970s, observes Dean Maki, chief economist at Barclays Capital. And there is evidence that the manufacturing sector has started to expand production, just six months after a sharp contraction in response to the credit crisis that began in fall 2008. In addition, the bulk of the $800 billion in government stimulus spending will enter the economy in 2010, which should add wind to the economic sails.

Double-dip recession

The most pessimistic scenario is that we'll fall back into another recession, as the spurt of economic activity of the summer peters out. The evidence isn't difficult to marshal. Conditions that could weigh down the economy include an unemployment rate of almost 10 percent; residential real-estate prices perhaps bottoming but leaving in their wake foreclosures and empty houses; a huge government deficit; seemingly stingy credit markets; and uncertainty about the U.S. dollar and increased inflation. Those problems could result in another contraction, as occurred in 1982.

Lessons from the past

Nobody expects history to exactly repeat itself. Most likely, this recovery will borrow from two or even all three of those scenarios and will have characteristics of its own for future economists to look back on and ponder. So we attempted to find out whether we could build a portfolio that could survive those three types of recovery.

We turned to historical data to see how certain types of investments played out in those past recoveries. We looked at the inflation-adjusted returns for four major asset classes for two years following the end of past recessions (see chart on facing page). And as it turns out, even in the worst-case scenario, diversified investors would have done well. This hindsight might be obvious now—on balance you would expect stocks to do well after a recession. But considering the trepidation among investors today, it's worth a closer look to help provide some guidance on how to move forward.

The first thing to notice is that contrary to what many people think, long-term Treasury securities are not necessarily the safest place to be. They fared best following the 1991 recession, gaining 27.5 percent. But during the double-dip recession of 1980 to 1982 they lost more than 8 percent in value. As the market historians at Ned Davis Research noted recently, long-term bonds make money when the economy is contracting and investors seek safety, which drives up prices. Since 1957, bonds have lost money on average during times of economic expansion. Somewhat curiously, bonds and stocks have appreciated in price this year. Normally the prices of those two assets move in opposite directions.

Another observation: After each recession, small-company stocks were the clear winner, something we've pointed out here in the past. Part of the explanation lies in the fact that small-cap stocks are usually sold off faster when the economy heads south. And during the latest recession small-caps lost a stomach-churning 60 percent, much more than the 37 percent that small-caps gave back in previous recessions. But as the economy improves, small-caps tend to snap back more quickly as well. In short, there's higher risk in small-cap stocks, but there's also a higher reward.

Large-cap stocks, on the other hand, tend to be the late bloomers, not outperforming until the recovery is well underway. Nonetheless, there's still a place for them in your portfolio before that point arrives: Large-cap stocks pay higher dividends, currently yielding about 2.2 percent, which rivals most certificates of deposit. So there are worse places to put your money right now.

From losses to gains

For diversified investors, even the bad news looks pretty good. Based on the three common portfolios we constructed, no money was lost over the two-year periods, even after adjusting for inflation, which was significant in the 1970s and early 1980s. The pie charts above show how three different asset allocations fared. What stands out again is the value of diversification—large tweaks in asset allocation didn't have much of an impact on total return. So moving forward from this recession, you'll probably be ahead of the game as long as you maintain broad diversification in your portfolio.

Of course, some observers still maintain that it's different this time. And that may be the case. In particular, today's investors have new assets with which to diversify, specifically foreign stocks and commodities. In the past it was impractical to add those to the average individual's portfolio, but today you can easily boost your diversification with exchange-traded funds and foreign mutual funds.

This article appeared in Consumer Reports Money Adviser.