How to Invest for an Economic Rebound

Here’s the not-so-bad news: We are nearing a bottom. Housing prices are falling, but not as rapidly. Consumer confidence is up. Banks are earning money. The stock market in April had its best month in nine years. Even Nouriel Roubini, the New York University professor known for his dire economic predictions, thinks we are on the mend. Sort of.

That’s not to say the recession is over. Roubini sees the road to recovery as a long and choppy one, with unemployment rising toward 12%. So don’t trade in your emergency fund for a boat. But when it comes to your investing life, it’s time to get back into the water. “People think that things need to go from terrible to terrific before they can invest,” says Fidelity’s legendary stock picker Peter Lynch. “But things only have to get to somewhat crummy for stocks to go up.”

So while the risk of seeing what’s left of our savings vaporized is fading, the question becomes: How do we ever get back the money we lost?

It depends on what type of recovery we have. Since the market bottomed on March 9, investors have rushed into acquiring shares of financial companies, retailers and technology firms. That makes sense if you believe we will have a recovery like the ones we’ve had in recent history. Companies in those industries did well in the market rallies that followed recessions in the 1990s and the early part of this decade. And stocks handily outperformed bonds.

But the current recession has been deeper and longer than the past two. “It’s a very different story today,” says First Eagle’s Jean-Marie Eveillard, one of the few managers to produce positive returns when stocks plunged earlier this decade. “The landscape is different, and the recovery, when it comes, probably won’t be along the lines of what we have seen in the post–World War II period.”

So here are three ways to think about investing for any recovery:

For the past few decades, the easiest call in economics was to predict a V-shaped recession–one that bottoms and rebounds quickly. It’s basically all we’ve had. Only two of the 11 recessions since the end of World War II have lasted more than a year, and nearly all wound up with a boomlet. Consumers stocked up. Companies upgraded their computers. We piled into real estate. And predicting a V may be the right call again. With the government spending billions on economic stimulus–trillions, if you include the bank fix–a quick pullout is entirely possible. In that case, buying retailers, technology companies and financial firms makes sense.

But at 16 months and counting, this recession looks more and more U-like–one in which a rebound takes time. That’s the picture Roubini is painting. He says no amount of government stimulus can make us shoppers again–we have too much debt. When paychecks resume or start to grow again, lenders will get that cash, not retailers. Consumer spending made up as much as 70% of the economy before the bust. With less shopping, Roubini says, there is little chance for a quick rebound. “If we do everything right, we can avoid an L-shaped near depression, which you don’t recover from,” he says. “But you still don’t get to a V.”

That’s significant because stocks were not the clear winner in the mid-1970s downturn, the last time we had anything close to a U-shaped recession. In the two years that followed, bond mutual funds returned 14%, vs. the 16% return produced by the average stock fund. This time around, Robert Arnott, founder and chairman of investment firm Research Affiliates, believes corporate bonds could do a lot better than stocks. Here’s the math: Corporate bonds have an average yield of about 6%. The average stock in the Standard & Poor’s 500 produces a dividend of just 3.1%. That means in order for stocks to outperform bonds, corporate earnings will have to rise more than 2.9% a year. And there is a good chance that won’t happen anytime soon. “Corporate bonds represent an impressive value,” says Arnott.

Even a prediction of a U-shaped recession and recovery could be optimistic. The trillions the government is spending to goose the economy add to our national debt and could hurt the value of the dollar. If that transpires, inflation will result. That’s what Warren Buffett recently told attendees at his annual meeting.

The best tool against inflation is interest rates. But if the Federal Reserve is forced to raise rates, the economy will most likely reverse into a recession. This is the double dip, or the W. In this case, your best bet could be Treasury Inflation-Protected Securities, or TIPS. The yield on these bonds increases with inflation. Surprisingly, stocks might also be a good buy. First Eagle’s Eveillard says inflation, while bad, is less bad for stocks than for bonds. “It gives companies the power to raise prices, and that is good for profits,” he says. Pricing power accrues to companies that can’t normally raise their rates–commodity producers like steel and timber companies and oil and other energy firms. Indeed, the shares of materials and energy companies rose 73% and 53%, respectively, in the first year of the bull markets that followed the back-to-back recessions of the early 1980s.

Of course, we won’t know what type of recovery we will have until we have it. Fortunately, you don’t have to position your portfolio for just one. As always, diversification can boost returns and lower risk–in this case, by including some investments for each of the three scenarios. If you are nearing retirement, your ideal is probably a mixture of corporate bonds and energy stocks. Bonds tend to be less volatile, limiting the chance that your portfolio will blow up. And energy stocks often pay dividends, which is something you may want when you are not working.

For younger investors, buying volatile technology and emerging-markets stocks is worth the risk. The economy is going to recover well before you retire. But balance out your portfolio with an investment in TIPS, just in case things get worse before they get better.