Investing With a Potential Recession on the Horizon

I broke my ankle pretty badly a couple of weeks ago. It’s going to take four to six months to heal. I’m wearing a walking boot now. And as far as I’m concerned, the walking boot might be the greatest invention since the printing press.

The walking boot allows me to be mobile. It allows me to move around relatively quickly (or as quickly as a person with a broken ankle can move). But as I walk around these days, all I notice are opportunities for me to break my healthy ankle.

Loose bricks on sidewalks. Potholes. Uneven pavement. Bumps in the road. I see them all now. The opportunities to injure myself seem limitless. And I tread carefully.

To a certain degree, investors today look at the economy the same way I look at the ground now. There’s danger everywhere.

Signs of a Recession

As I write this, the S&P 500 (SPX) is down almost 5% in 2022. The Dow (DJIA) is down almost 4%. The Nasdaq Composite Index is down more than 7% this year.

The Fed’s key inflation rate is up 5.4%. And last week, we saw a yield curve inversion. That’s when the yields on short-term debt exceed the yields on long-term debt. That’s not supposed to happen. In theory, when someone invests in a debt instrument, the investor should get higher returns for investing in long-term debt. That’s the reward for losing access to the capital invested.

When the yield curve inverts, investors get higher yields from short-term debt. This bizzaro signal is often an indicator that a recession is on the way. You’re not supposed to be rewarded with higher returns when you invest in short-term debt. And when that happens, it indicates that something might be wrong with the economy.

There’s a lot of noise surrounding this particular signal. Jobs reports have been strong. But more importantly, we have an economy that’s emerging from a pandemic and a war in Ukraine.

So a recession in the next couple of years is far from a certainty. But it’s definitely a possibility that investors need to account for. As is the fact that many investors will likely see the value of their stock portfolios drop this year.

Look to the Long Term

So how should savvy investors handle this uncertain environment? Reducing exposure to the bond markets is a good place to start. Investing in bonds right now is like lighting money on fire. Inflation eats up any potential returns.

Longer-term investments make more sense in this environment. That can be stocks that can survive near-term volatility or assets that will come of age after this economic uncertainty washes away.

Startups fall in the latter category. In fact, they’re one of the few asset classes that can both weather short-term economic uncertainty and generate significant long-term profits.

But with inflated valuations, investors have to be pickier than ever when choosing which startup opportunities they want to invest in. They also have to be more open-minded. 

Being both open-minded and picky might sound paradoxical. But solving this paradox is the key to startup investing in this environment.

The way people live and work is in flux. Remote work — even if we’re unsure of its final form — is here to stay. That impacts everything — including where we live, where we eat, how we shop, how we socialize and the infrastructure needed to support this “new normal.”

The pandemic revealed just how fragile our supply chain is. And the labor markets are so tight that in some sectors, it’s almost impossible to find or hire workers.

These are all big systemic problems that need to be addressed. And these are the types of problems that startups excel at dealing with. But nobody knows exactly what the solutions to these big issues look like right now. So investors have to be open-minded. Startups are going to envision and try novel concepts. Some will work. Some won’t. The trick is not to reject all of them because they’re new or unconventional. These startups are tackling big problems that require innovative solutions. So investors need to be open-minded and look at everything with fresh eyes so they can identify the startups with the best chances of success.

Once investors have identified a range of potential startups to invest in, then it becomes time to get picky. The key is “de-risking” the investment — or taking as much risk off the table as possible. Investors should ask themselves…

• Will the product work? 
• Will the market want it? 
• Will it be able to compete effectively with future solutions? 
• Is the valuation or revenue multiple too high? Or can investors generate a good return if things don’t go perfectly? 
• What’s the floor of the company?
• What are the returns if things go well? As an investor, are you comfortable with that range of outcomes? 

Remember, all startup investing involves risk. The whole enterprise could fail (and they often do). The key is determining whether the potentially large rewards of any startup investment is worth the risk. 

There are startups worth investing in. And investors can find them as long they’re both open-minded and picky. We’re scouring through our deal flow right now to bring you one of those opportunities in the next few weeks.