Sectors & Stock Selection / July 27
Administrative Notice: the editorial team will be on vacation July 28 - August 7; the usual updates and articles will pause in this period. We are constantly monitoring market developments and system functioning.
Anticipating the Market’s Bottom: How Investors Should Navigate Portfolio Management
After the stock market finally succumbed to bear market territory on June 13th, investors have been frantically searching for signals of hope, wondering where the bottom is, and planning for a challenging economic reality ahead. In the last week of June, long-term Treasuries, TLT, performed better than the S&P 500, SPY, by over 5%. At first glance, this situation signals to investors that ominous markets are ahead and other investors are trying to hedge against stock market volatility. While there is some truth in that process, it’s important to dive a bit deeper. We present different methods of analysis that could help you manage your portfolio in these trying times.
SPY / TLT Relative Analysis
The premise: overweight stocks when ratio is low, overweight bonds when the ratio is high.
Most of our ETF charts feature a relative to SPY analysis (the toggle is in the upper left corner). SPY is benchmarked against TLT, since it broadly represents the performance difference between stocks and bonds. The Z-Score of SPY / TLT is a reading that tells us the speed that interest rates change relative to what equities are currently pricing in. It is a core ratio that affects the behavior of the Enterprise strategy.
As financial conditions tighten, it is not surprising to see treasuries outperform, sometimes abruptly. Throughout the last two decades, TLT has only outperformed SPY by 5% in a week 62 times. When analyzing those instances, 85% of the time, the S&P 500 has been higher within one year, with an average gain of 19%. On the surface, recent TLT behavior is worrisome, but it could be signaling that the market is turning a corner.
Sector Analysis
The premise: overweight low beta sectors in times of market drawdown.
Though there are many factors at play right now, making this bear market a wildcard, we can look at history to see how various portfolios fared after a market correction. As markets trend downward, our bias is to invest more heavily in sectors such as consumer staples, healthcare, and energy, which often offer reliable dividends and historically showcase more stability than volatile industries such as technology. Their relative outperformance to SPY, low volatility and low beta is also an advantage in a downturn.
Sorting sectors by their 6 month excess returns vs SPY, yields an order that favors low beta instruments. That is because these sectors are not the ones dragging the market down, but instead are the outliers with average positive returns.
According to CFRA data, in the last 14 bear markets since 1945, it took an average of 12 months to find the bottom and an average of 23 months to recoup losses. If the Federal Reserve can slow economic activity without triggering a recession, “this bear market may bottom soon,” says Ryan Detrick, chief market strategist at LPL Financial. We remain skeptical of that view, since the conditions that dictate the current environment are truly unprecedented in modern times.
When the market finds its bottom, look to the Federal Reserve’s policy on interest rates. Since the cost of borrowing money is rising, financial institutions and that sector of the stock market are taking a major hit. Once the Fed slows down its interest rate hikes or decides to peel back some of the rate increases, there will be a flood of people trying to borrow money again, boosting the financial sector quickly. However, there’s a catch.
Right now, people are busy front-running the Fed and proclaiming that a “dovish pivot” is in the cards as early as September. Within this paradigm, a Q2 negative GDP print would be cheered, as weakness in the economy would indicate to the Fed that it’s time to slow down. When people should be clamoring to borrow money again and start taking on more risk - they will be very reluctant to do so. At the bottom, no one wants to buy.
So how should we go about selecting stocks when all is said and done? Our systematic research contains a couple of pointers. First of all, don’t overlook the power of fundamental investment strategies that have stood the test of time. Timing the market is nearly impossible; instead, focus on dollar cost averaging techniques throughout the market correction. Additionally, underestimating the value of blue-chip stocks during lulls in the market is a missed opportunity. Stocks of companies with strong cash flow, robust balance sheets, and regular dividends are often considered “on sale” during a correction. Anessa Custovic, chief investment officer at Cardinal Retirement Planning believes that “getting them at this low price and waiting for the recovery will help recover losses and likely result in gains in the long run.”
Blue Chip Relative Outperformers
The premise: Market Cap is a factor that provides safety; Relative Z-Score favors stocks that are currently outperforming their peers.
Set Market Cap (Col. 1) to minimum 35.000 - this will filter our universe to the top 200 (or so) companies by market capitalization;
Set Column 2 to Z-Score Relative; set it to minimum 0, so that all stocks are relative out-performers when judged against peers;
Set Column 3 to Beta to SPY; set it to minimum 1, so that we filter out defensive stocks that have out-performed without being correlated to the market; we are interested in selecting stocks that have actively dragged down the market - the high beta ones;
Set Column 4 to Dividend Yield; set this to minimum 0.2, so that we filter out companies that pay no dividend;
Set Column 5 to Pietroski F-Score; set this to minimum 6, so that only companies with robust fundamentals get included in the final portfolio.
This method of stock selection aims to provide safety from different perspectives: High market cap companies are traditionally less prone to going bankrupt; Stocks that are outperforming their peers during a market drawdown are the ones that rebound the fastest; Paying a dividend provides investors with a guaranteed return for owning the stock, while also weeding out low quality companies; A higher Piotroski F-Score also provides extra fundamental safety in the process of screening.
In the end, only 10 companies meet every criteria, and we would be comfortable owning these names through a downturn.
Takeaway:
Every investor will have a different level of risk that they can withstand during times of market volatility, but no matter where you are in your investment journey, operating slow and steady usually pays off after some time. No one can say exactly what the market will do, but by looking at historical corrections and the months that followed, it becomes clear that eventually, things will look up again. We will prepare by owning the right asset classes and the right portfolio when things start looking up again.
Andrei Sota & Jerica Kingsbury