What Classes of Mutual Funds Perform Best in a Down Economy?

In past market downturns, a few stock classes have performed better than the market generally, including consumer non-cyclicals, value stocks and (perhaps counter-intuitively) a sub-class of cyclicals -- luxury goods. Investors should note, however, that determining when the economy has entered a downturn is only easy in retrospect. Another complication -- the economy and the stock market are only loosely correlated. The economy may be stuck while the market makes solid gains.

Consumer Non-Cyclicals

Consumer non-cyclicals, sometimes termed "consumer defensives" or "consumer staples," are companies that farm and produce food, manufacture and distribute household goods and provide a variety of basic services. Stocks in these companies tend to hold up well in downturns because their products come closer to being actual necessities than consumer cyclicals, such as automobiles, houses and durable goods, which a consumer can delay buying or do without. You can ask your broker to suggest top-performing mutual funds in this sector, or you can go to your online broker's research section and use the screener. A recent search at one online brokerage used these screens: an average annual return of 15 percent or better and investment in consumer staples of 50 percent or more. This search produced eight mutual funds. You can create more detailed screens to suit your particular investment preferences.

Luxury Goods

Consumer staples hold up well in downturns because most consumers need them and can afford them. The luxury goods market provides products that few of us can afford and almost no one really needs. Because the target audience -- the buying power of the very wealthy -- tends to be relatively unaffected by normal economic downturns, the luxury goods market does very well in economic downturns.

Value Stocks

Value stocks have low P/Es (price-to-earnings ratios), low P/Bs (price-to-book ratios) and high dividend-to-price ratios. These may be new companies, companies with unglamorous products or troubled histories, or those that are in other ways undervalued by the market. Since 1966, value stocks have outperformed their more glamorous counterparts -- growth stocks having recent above average earnings, sales and cash-flow -- by about 2.5 percent. These stocks do particularly well during economic downturns. Mark Hulbert, editor of The Financial News Digest, notes that in the 2000-2002 economic recession, value stocks actually made money. Ask your broker to recommend top-rated value funds, or use an online screener to identify them yourself.

Two Cautions

Knowing which fund classes perform best in downturns is easier than identifying the downturns themselves. A sharp drop in stock prices may only be a pause in a bull market. Identifying the inflection points where bull markets end and significant downturns begin is an inexact science. Economic downturns and stock market declines are only loosely correlated. For example, between March 1998 and March 2003, the stock market declined slightly, while U.S. GDP rose by more than 10 percent.