Volatility often compels investors to search for pockets of safety in the markets. But beware of following crowds to popular safe havens. Flexible, active approaches can defend against downturns while taking advantage of attractive opportunities.
Piling into crowded trades can be risky, as a change in sentiment can send everyone running for the door at once. Yet since mid-2015, turmoil driven by China, recessionary fears and a spike in volatility has prompted equity investors to flock to sectors perceived as safer.
The utilities and consumer staples sectors have become such popular refuges from volatility that their valuations have risen to elevated levels. That doesn’t mean investors shouldn’t buy stocks in these sectors. But we believe that it’s important to be selective by focusing on fundamentals in order to identify the most attractive opportunities. Having a solid offensive plan can help protect a portfolio from downturns and is one of several ways that active investors can capture excess returns over long time horizons
Take a Barbell Approach
So what should investors do? When there is heightened uncertainty in the market, we believe that it can be effective to invest in a “barbell” portfolio, which balances exposure between high-quality, less cyclical stocks and exposure to some cyclical stocks that have solid fundamentals.
Just a few months ago, this approach was a good way to invest as fears of a downturn dominated market sentiment. Today, recession concerns have receded as several positive forces continue to support the US economy. These include record low interest rates, consumers’ strong household free cash flow and wealth, a healthy banking system, a weakening US dollar, and stabilizing commodity prices. As a result, we believe that it’s a good time to shift toward the more cyclical side of the barbell, by increasing exposures to high-quality companies within sectors such as industrials, energy and financials.
At the same time, it’s important to maintain some carefully chosen defensive positions as an insurance policy, in our view. Today, in the healthcare sector, investors can find high-quality stocks with promising long-term growth prospects at attractive prices, because of the continued concerns of drug-pricing pressures.
Minimize Market Exposure
For investors seeking a more defensive solution, a portfolio that manages its exposure to equity markets by taking long and short positions may help provide support during difficult markets. For example, in 2008, long/short equity managers, as represented by the HFRI Equity Hedge Index, provided investors with a degree of protection from the movements of the overall market.
That year, the average long/short fund was down just 27% while the S&P 500 fell 37%. These types of constructions can provide a solid defense for a deteriorating economy while also providing upside potential if a worst-case scenario is avoided and the economic recovery persists—or accelerates.
Stick to Your Game Plan
Nobody has a crystal ball to predict the future direction of the US economy. But even if things do get worse, it’s important to remember that every downturn has different drivers. For example, back in 2000, the recession was caused by the bursting of the Internet bubble. Capital investment in technology tumbled and stock prices in the tech sector fell by a cumulative 59% over the next five years. Yet over that same period, homebuilding was the best sector in the stock market, as prices rose by a cumulative 544%. So with the right perspective on economic conditions, investors can position effectively to stay with equities and avoid trouble spots during tougher times.
A good defense for difficult markets can be built by following a disciplined strategy for the long term. Hiding out in the same places as everyone else may provide an illusion of security that won’t necessarily prove safe when markets shift from risk-off to risk-on mode. Instead, look to experienced investors who know how to create a balanced portfolio of companies with both solid long-term prospects and the ability to hold up well during a downturn.
This blog was originally published in InstitutionalInvestor.com.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.