In an article yesterday, I highlighted some of the sectors and stocks that tend to perform relatively well in a market crash. Going back to last decade’s great financial crisis and recession, the FTSE 100 fell 47.5% from peak to trough over 18 months or so. The 11 stocks in three sectors I discussed averaged less than half that decline over the same period.
Of course, this means some stocks fell far, far further than the 47.5% of the index. Today, I’m looking at which sectors and stocks might be vulnerable to the heaviest crashes in the next market meltdown.
The best performers in bear markets tend to be companies in industries whose earnings are less dependent on the state of the economy than those whose fortunes are heavily geared to it. As such, in looking for stocks that could be hardest hit by a severe economic downturn or recession, the most highly ‘cyclical’ sectors are my first port of call.
Historically, banks and housebuilders have been prominent among the most severely impacted sectors when the economy turns south. The share prices of bailed-out Royal Bank of Scotland and Lloyds were utterly crushed by the financial crisis a decade ago, and are still a mere fraction of their pre-crisis highs. Due to massive share dilution, it’s doubtful they’ll ever get back to those levels, at least in my lifetime.
Housebuilders’ share prices were also absolutely hammered. The big three of the FTSE 100 – Barratt, Persimmon, and Taylor Wimpey – fell between 85% and 98%.
Too good to be true
Banks and housebuilders are currently trading on low forward price-to-earnings (P/E) ratios and high dividend yields: RBS (P/E 8.8 and 10.8% yield), Lloyds (8.0 and 5.8%), Barratt (8.7 and 7.4%), Persimmon (8.5 and 10.3%), and Taylor Wimpey (8.3 and 10.7%).
Now, with highly cyclical stocks, low P/Es and high yields are typically what we find going into a cyclical downturn. So seductive do the valuations become that many investors forget the old adage, “if something looks too good to be true it usually is.”
Personally, I see the five stocks mentioned above as ones to avoid, until their next earnings-and-dividends crash, when their P/Es will be sky high, or off the scale (negative earnings), and they’ll have little immediate yield appeal. It’s counter-intuitive for value investors, but history says this is the time to buy highly cyclical stocks.
Another type of stock I’m wary of after a debt-fuelled, decade-long, global, bull market is the highly rated growth company, where irrational exuberance may have driven the share price well above the intrinsic value of the business.
As economic downturns generally involve earnings disappointments, the market can viciously sell off previously high-flying stocks. In the FTSE 100, I’d count Autotrader, Hargreaves Lansdown, and Rightmove – all sensitive to the health of the wider economy – among the at-risk stocks in this category.
Finally, over the years, there always seems to be some investment trust or another that becomes so popular it gets pushed up into the FTSE 100. However, they never last in the top index, dropping out like a stone in a market downturn and/or if their investment style goes out of fashion.
The current representative of this phenomenon is Scottish Mortgage, which has basically surfed the huge rising valuation wave of US and China tech stars. I’d expect Scottish Mortgage to fall heavily (and out of the FTSE 100) in a market crash.
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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has recommended Auto Trader, Hargreaves Lansdown, Lloyds Banking Group, and Rightmove. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.