JonathanBurton

SAN FRANCISCO (MarketWatch) — The R word is being spoken louder.

The chance that the deepening housing downturn will drag the broader U.S. economy into recession is troubling more investors. With so many Americans borrowed to the hilt against their home equity, many investment strategists and economists are viewing the housing slump as the tipping point that sinks consumer spending at a time when U.S. businesses aren’t reaching for their checkbooks either.

With housing starting to show some weakness and energy prices remaining where they are, the risks are building and starting to take a real toll on the consumer, said Jeff Mortimer, chief investment officer for equities at Charles Schwab Investment Management.

Whether in recession or retreat, an economy in decline brings investors new challenges — and opportunities. Talk of the economy making a soft landing or a hard landing has important implications for stock prices. But the preparations are for landing, not take-off. Accordingly, decisions that worked in the early and middle stages of the economic expansion now give way to investments more akin to what market pundits call late cycle plays.

A well-diversified investment portfolio is better able to withstand whatever blows the economy delivers. Diversification cushions unexpected market risks you can’t control. So any portfolio shifts made in expectation of a sluggish economy later this year or next should be moderate, not manic. After all, while the investment horizon looks cloudy, a storm may not strike. You just want to be ready.

In these waning innings of the U.S. economic cycle, fast-growing small-capitalization stocks, high-yield bonds, emerging markets, commodities, metals and other riskier, lower-quality investments are out. Defensive, high-quality, dividend-paying large-cap U.S. and international stocks, short-term bonds, bank certificates of deposit and everyday cash are in.

There’s more concern about the magnitude of any slowdown, said Alec Young, an equity market strategist at Standard & Poor’s Inc. A defensive approach makes more sense.

1. Go big; buy quality

An old investing adage dictates that when earnings growth is abundant, the market prices it like water. When growth is scarce, it’s priced like diamonds.

When the economy slows, many companies fall short of the earnings growth that Wall Street expects. The institutional investors and hedge funds that move stock prices tend to have a short-term focus, and they are unforgiving of companies that miss the mark.

In a downturn, negative earnings surprises are more likely to hit smaller firms that are having difficulty finding the financing and customers needed for growth. Companies in cyclical industries such as technology, luxury items and other discretionary consumer goods, real estate, investment banking, commodities and industrial materials are particularly vulnerable.

Markets hate uncertainty, so investors then embrace companies that can deliver predictable growth — a higher quality of earnings. Such firms tend to be larger, with strong footprints in solid industries and steady streams of cash to run the business and pay dividends. While these stocks can certainly slide in a slowdown, they typically will lose less than their smaller rivals.

Larger-cap companies are going to do better, said Ted Parrish, co-manager of the Henssler Equity Fund HEQFX, -0.72%

They are going to find it easier to finance projects they find to have higher returns, Parrish added. They are going to find that any borrowing they need to do is going to be at favorable rates. Smaller-cap companies won’t; it’s going to put more of a strain on their balance sheets.

2. Defense: Consumer Staples

In the final months of a business expansion and during a subsequent contraction, the top performing sectors are those with the most reliable source of profits.

A defensive approach makes more sense. — Alec Young, S&P

The consumer staples sector — companies involved with manufacturing and selling of food, beverages, tobacco, household products and personal care items — has historically held up well at such times.

People are buying these things regardless of economic conditions, said Young, the Standard & Poor’s strategist.

Large-cap consumer staples companies also tend to pay meaningful dividends — and steadily raise them — enhancing their overall quality and appeal. Dividend income is always welcome, but especially so in choppy markets when you’re effectively paid to wait until the turmoil subsides.