So far, we have managed to avoid an actual economic recession, much to the disappointment of the bears.

The latest data out last week shows that our economy expanded at a better-than-expected 2.6% annualized pace last quarter — sluggish, to be sure, but far from a recession.

But I don’t put much faith in backward-looking economic data like this anyway. The Beltway bean counters seldom get it right, but they are never in doubt.

Instead, I prefer to follow higher-frequency, real-time data, like earnings estimates. And right now, this data is forecasting an earnings recession (two consecutive quarters of corporate profits coming in lower than they did a year ago), if not an economic one.

Exhibit A, as you can see above, is the Citigroup U.S. Earnings Revisions Index. It compares the number of Wall Street analysts’ downgraded profit estimates on stocks to the number of upside revisions.

And as you can see at far right, earnings revisions have been running in the red (negative) since midyear. This is not good news, but it’s not the end of the world, either.

As things stand, analysts are still forecasting 6% to 7% profit growth for the S&P 500 in the third quarter. But the increase in downward revisions to those forecasts is troubling.

Earnings revisions typically go deeply negative near market bottoms, that is, after lower earnings estimates have already been fully priced into stocks. And there have been plenty of times in the past when earnings recessions took place without the bottom also falling out of the economy.

The most recent was from late 2018 into 2019, when earnings revisions were consistently negative. But no broader economic recession followed, and the S&P 500 gained nearly 30% in 2019.

Still, it’s a good idea to ensure that your investment portfolio is prepared for an earnings recession. That’s because the type of stocks that perform best at times like this may not be what you expect.

Plenty of folks will tell you to go with growth stocks that can reliably increase profits no matter what. But these stocks can pose greater risk to investors, as their high prices can plummet dramatically if the company happens to miss earnings expectations.

Others gravitate toward value stocks. But undervalued cyclical stocks can easily get even more undervalued.

When it comes to resiliency during an earnings recession, quality, low-risk, dividend-paying defensive stocks are where you’ll want to put your money.

In particular, health care, consumer staples, and utilities have been the best-performing sectors during earnings recessions, according to data from Richard Bernstein Advisors.

These three sectors have all posted total returns of more than 20% when profit growth slows.

TradeSmith offers a terrific stock screening tool that I use all the time to come up with my best recommendations. So, this week I used it to zero in on the best health care, consumer staples, and utilities stocks.

I also screened for stocks that are in our Health Indicator Green Zone and in an uptrend. Plus, I filtered for stocks with the strongest free cash flow, which signifies that the company has a healthy store of cash on hand for paying dividends and otherwise increasing shareholder value.

The result was a list of 18 quality defensive stocks. Here are three that stood out to me, one from each sector:

  • Health Care: Merck & Co. Inc. (MRK), a pharma giant and Dow 30 blue chip with a 2.7% dividend yield.
  • Consumer Staples: Archer-Daniels-Midland Co. (ADM), a farming products and services company with $2.79 billion in free cash flow over the past 12 months.
  • Utilities: National Fuel Gas Co. (NFG), a natural gas utility company with a 3% dividend yield.

These stocks are perfect examples of what you want to own to potentially outperform during an earnings recession.

— Keith Kaplan

Source: TradeSmith