Positioning in volatile times

By Guest Blogger Ryan Lewenza

Is it me or are we in a particularly volatile and uncertain time right now? The headlines are downright scary these days. In no particular order I’m concerned about the impact from Trump’s ongoing trade wars, the newly elected UK PM Boris Johnson and his willingness to leave the EU with no deal, the crumbling Iran nuclear agreement and their recent transgressions (e.g., shooting down a US drone and seizing a British oil tanker), climate change, which is leading to record temperatures across Europe, increased flooding, wildfires and droughts, and the slowing US/global economy, as evidenced by the big drop in government bond yields and currently an inverted yield curve.

It’s no wonder then that we’ve seen an increase in market volatility over the last few years. While 2017 was a dream with very little market volatility, since then we’ve seen some material market declines. As seen below, the S&P 500 has experienced three 10% corrections and one 7% sell-off since the beginning of 2018. So given this environment the two key questions are: 1) is this increase in volatility the precursor to a more significant economic slowdown and market decline; and 2) how should investors be positioning their portfolios?

The S&P 500 Has Experienced Increased Volatility

Source: Stockcharts.com, Turner Investments

First, despite my stated concerns above, I remain fundamentally bullish and see a recession and bear market as remote over the next 9-12 months. This view is predicated on: 1) while the US/global economy is slowing it continues to grow a healthy clip, likely around 2.5% in the US and 3.5% globally for this year; 2) the global central banks are responding to the slowing global economy by cutting interest rates, thus adding stimulus and support to the economy; 3) I am not seeing any significant credit/market excesses like that seen during the tech crash of 2000 and the subprime meltdown of 2007; 4) any resolution to the Trump/China trade war could provide a catalyst to the global economy and equity markets; and 5) technically, the equity markets look great with the US equity markets recently breaking out of their year-and-half long trading range, making new all-time highs. Given this we continue to position portfolios for more upside.

However, risks remain elevated, as noted above, and therefore we continue to reduce risk in client portfolios by switching higher risk positions for lower risk ones. Below is a great visual from Blackrock that essentially captures how we construct and adjust portfolios over time.

Steps to De-Risk Portfolios

Source: Blackrock

Our first line of defense to these risks is our balanced portfolio of 60% in growth equities and 40% in safer fixed income. The bonds help to smooth out portfolio volatility and provide a hedge to our growth equities.

Then, based on our economic and fundamental outlook we adjust our security holdings. When things look great (economy is surging, earnings are rising, central banks are keeping rates low) we favour higher growth investments like US small caps, technology, and high yield bonds. I call this phase 1 of cycle investing.

As the business/market cycle matures and central banks begin to hike rates to help moderate the economy and inflation, we move on to phase 2, which entails de-risking the portfolio by investing in lower risk, lower volatility stocks. This is where we stand today. Specifically, this includes buying ETFs of low volatility stocks and REITS, a focus more on high-quality blue chip companies that pay dividends, investment grade corporate bonds and some government bonds, and a slightly higher cash balance than normal. This is exactly how we’ve been positioning portfolios over the last year or two. For example, we’ve been locking in profits on our small and mid-cap positions and adding to lower risk equities like blue chip dividend and healthcare stocks.

The final phase is phase 3, which entails positioning portfolios for the dreaded recession and bear market. This would include buying more government bonds and increasing cash. During these periods we’re not trying to make clients 6%, we’re trying not to lose them 20%. Fortunately, these dreaded bear markets are short in nature (they last on average 11 months), and are always followed by recovering bull markets.

Now to be clear, in this phase I’m not talking about selling all equities and going to cash since that’s timing the markets, which is very difficult to do consistently. Rather, I’m talking about tweaking the portfolio and taking extra precautions in a very challenging macro environment.

In summary, I view investing in 3 phases and believe we’re currently in phase 2, which entails positioning portfolios for continued growth, but taking smaller ‘bets’ by investing in more defensive investments like low volatility stocks, REITs, healthcare and high-quality bonds.

That’s where we stand today, how about you?

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.