Market volatility is an expected by-product of any significantly negative macroeconomic news or event. But in the days following the S&P's August 5th decision to downgrade the long-term U.S. credit rating from AAA to AA+, market fluctuations were even more convulsive than most people anticipated. Less than a week after the August 5th announcement, roller-coaster vacillations occurred intra-day, including a late-day rally in the Dow Jones Industrial Average of 4 percent, or 429 points, that was all but obliterated by a 4.2 percent, 519-point drop the next day. All told: the market was rocked by four triple-digit swings in a five-day period-a shocking and upsetting occurrence.
Global aftershocks followed. Tokyo stocks tumbled; indexes in Spain, France and Germany-which face problems of their own--shed more than 5 percent of their values each over the same five-day period; and the health of French financial institutions came under question. In the flight?to?quality rally, bond investors clamored to buy-what? U.S. Treasury 10-year notes at a record low yield of 2.14 percent.
By all measures, market volatility shot up to levels unseen since the crisis of 2008. But that doesn't mean we are caught in the same predicament as we were then. Although our latest spell of volatility undeniably recalls the unpleasant memories of 2008's turmoil, the current economic landscape appears to be favorably different in many ways.
In addition to a brighter fundamental picture, perhaps the biggest distinction is the leverage burden that crippled private sector market participants such as banks, hedge funds and individual investors when the credit crisis hit. In 2008, after finding themselves suddenly exposed to critically high risk, investors began feverishly dumping their stock positions. Vast amounts of high-quality issues were sold at cheap valuations, pushing the market further down a rabbit hole, and provoking vicious rounds of deleveraging that lasted well in to 2009 and ravaged many individual investors' portfolios.
Fortunately, in this instance, history is not likely to repeat itself. This time around, the leverage burden is being shouldered less by private capital because of deleveraging. It now rests primarily in the hands of the government, which doesn't have to satisfy capital requirements and is not likely to engage in panic selling. Still, the psychic scars of 2008 remain fresh for many investors, and without proper guidance, some are likely to make snap decisions and go to cash.
Keeping A Cool Head
Of course, during periods of volatility, clients are tempted to divest their equity holdings--full scale. Watching valuations ricochet is stressful. But a far more strategic would be to rebalance portfolios back to their original long-term allocations, with an eye toward the opportunistic overweighting of equities and underweighting of fixed income. The current environment should also benefit active managers who have a demonstrated track record in picking stocks. These managers have experience identifying financially strong, high-quality companies, and with several valuations at the lowest in a generation, they know that attractive risk-return opportunities can be exploited and should ultimately give holders of those stocks a significant edge.
In this market, due to their often superior financial strength, large caps names are generally doing better than small-cap names. In addition, growth stocks tend to outperform value, as investors place a premium on companies that can generate earnings growth in an environment of little or no economic growth. In terms of sector bias, we would recommend a tilt towards defensive sectors in general, and more specifically, stocks within those sectors that promise high dividend yields, such as utilities, consumer staples and telecom services.
Healthcare firms with strong and sustainable growth models look good, while technology names are always interesting at times like this. Invariably less economically sensitive than other sectors, technology is less likely to be buffeted by interest rate swings that may come down the pike due to the low amounts of debt they maintain. Furthermore, tech names tend to have strong and stable cash flows with vast cash reserves on their balance sheets. Witness Apple, which currently has about $50 billion in cash and other current assets. Or Google, which just announced a $12.5 billion all-cash deal for Motorola Mobility. True, these stocks typically pay little or no dividends, but they're strong, liquid, and appear to have tremendous growth potential.
These broad stock suggestions by no means trivialize the challenges of finding good names when we know the overall market can easily slip 4% or more in a single day. But good managers will be able to navigate the maze of companies in order to ferret out ones most likely to rise above the fray.
Not For Everyone
Of course, certain investors cannot be talked into maintaining the equity components of their portfolios regardless of the stock-picking prowess of their managers. Emotions run too high for those investors who can't shake fears that they'll never make it through the downdraft unscathed. In situations where clients are deeply pessimistic, advisors can allocate to non-correlated asset classes, such as commodities, as well as liquid alternatives--hedge fund-like vehicles that are housed in mutual fund formats and capable of shorting names and/or indices. We would recommend that the allocation to non-correlated assets be taken proportionally from the portfolio's equity and fixed income allocations.