Playing defence

RYAN By Guest Blogger Ryan Lewenza

This week I’m going to pull back the curtain and highlight a few of our key investment themes. Just like a magician, I can’t give away all of our tricks but here’s a few ideas that we believe could do well in the current market environment.

I should start with a quick summary of our market outlook and portfolio positioning. We remain bullish with our constructive view predicated on the following: 1) our generally positive view of the US/global economy heading into 2020 (i.e. no recession); 2) our expectation that earnings growth will pick-up over the next 12 months; 3) central bank easing with the Fed cutting rates this year and the ECB/BOJ keeping rates at rock bottom lows; 4) supportive market cycles like the Presidential Cycle; and 5) the technicals, which remain demonstrably bullish with global equities in a long-term uptrend and above the rising 200-day moving average.

Here comes the but or the however, while we’re constructive on the economy/equity markets, risks remain elevated (e.g. Trump’s trade war, Brexit, Hong Kong), and given these risks we are looking for creative ways to position for more upside, while reducing risk in our holdings and the overall portfolio. Essentially, we’re taking smaller bets with our client’s hard earned savings. We think this is prudent given where we are in the business/market cycle.

Against this backdrop one great way to play for more upside but with lower risk is though low volatility ETFs. These ETFs screen the different equity markets for those stocks with the lowest volatility. The ETFs are also rebalanced, generally quarterly, by kicking out those stocks that experience an increase in volatility. This helps to ensure the ETF is zeroing in on those stocks with the lowest volatility and is adjusting to changing market conditions.

The chart below really hits home the attractiveness of low volatility stocks and why we believe this is the right time to own them. I calculated rolling, long-term volatility (standard deviation) for both the S&P 500 Index and the S&P 500 Low Volatility Index, which holds 100 of the lowest volatile stocks within the S&P 500. Note how the Low Vol Index consistently exhibits lower volatility by roughly 25%.

Now you would assume the returns would be significantly lower, but this has not been the case in recent years. For example, over the last five years the S&P 500 Low Volatility Index has returned 11.75% annually, beating the S&P 500 Index at 10.34%. Now as they say, past performance is no guarantee of future results, but I do believe the Low Vol theme could continue to perform well, at least until the next bear market, where we would then likely exit this theme/position.

Low Vol Reduces Equity Volatility by 25%

Source: Bloomberg, Turner Investments

Next up is our preference for US value stocks over growth stocks. Over the last decade growth stocks have been the clear winner with the S&P 500 Growth Index up 272% versus the S&P 500 Value Index up 193%.

We believe this is going to flip with value stocks set to outperform growth stocks over the next decade. Fortunately, we’re in good company with JP Morgan’s highly regarded quant analyst, Marko Kolanovic, recently stating that “the value rotation should continue into Q4 and Q1”, and more assuredly, that this rotation is “once in a decade”. That’s a bold a statement, and is up there with Trump’s claim that the Ukraine call was “perfect”.

Value stocks, at times, can be more defensive than growth stocks. For example, in last year’s Q4 sell-off value stocks declined 18% versus the S&P 500 at -20% and growth stocks at -21%. One reason for this is their cheaper valuations. Currently the S&P 500 Value Index trades at an attractive 16x earnings versus the Growth Index at 26x. I believe that if the equity markets come under pressure that value stocks could hold up better than growth stocks due in part to their lower valuations.

Value stocks are a good holding for us right now given the mix of decent upside in the coming years and that they tend to fall less than the overall market during downturns.

Value Stocks Are Attractively Valued

Source: Bloomberg, Turner Investments

Finally, readers of this pathetic blog know that we are strong proponents of holding REITs in portfolios given their high dividend yields and solid long-term returns. This year is case in point with REITs up over 23%, beating the TSX. We like REITs as they can provide a hedge to a weaker economy and stock market as they are negatively correlated with interest rates. Below I illustrate this where I chart the Canadian REIT Index with government bond yields (note: the government yield is inverted to better show the relationship).

Historically, REITs have a negative correlation of -0.64 to government bond yields. In simple terms, they often do well when government bond yields decline. So if markets do come under pressure and bond yields decline then REITs could do relatively well.

REITs Provide a Hedge to Lower Interest Rates

Source: Bloomberg, Turner Investments

As I’ve laid out today, we see the potential for further market gains. But this call is no slam dunk given the myriad of risks that exist today. So to hedge our bets we’ve been reducing risk in portfolios by investing in lower risk ETFs like low volatility, value and REIT ETFs, which should hold better in a downturn should we be wrong.

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.



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