Where to Ride Out the Volatility

Fri, Jan 29, 1:08 PM ET, by , BlackRock

The one word that characterizes financial markets today: volatile.

Take last week’s gyrations. Stocks sold off aggressively for most of the week on concerns about plunging oil, falling U.S. earnings estimates, China and slowing global growth. Amid the selloff, Japanese, U.K. and French stocks all entered bear market territory, according to MSCI index data accessible via Bloomberg.

Then, markets rebounded strongly late in the week, thanks in part to dovish comments from the European Central Bank (ECB).

Indeed, volatility measures have spiked to multi-month highs lately, with 2016 experiencing the worst start to a year in market history, according to Bloomberg data. The volatility is leading many investors to exit stocks. For those that remain the key question becomes: Where to hide?

Under more normal conditions, the simple answer for U.S. investors, particularly when volatility is being driven by concerns over growth, is to re-allocate to more defensive, less economically sensitive parts of the U.S. market. Examples include certain sectors: utilities, consumer staples and often, telecommunications.

The traditional logic is that these sectors are less exposed to the pace of economic growth, and therefore, their earnings should hold up better in a downturn. However, this approach may not work this time around, because the volatility is largely being driven from outside the United States, i.e. China. Further complicating matters, after years of investors favoring these sectors for their dividends, many of these sectors are expensive. Finally, should market volatility begin to stabilize and interest rates climb a bit, these defensive stocks would be particularly vulnerable.

So, rather than focus on defensive sectors, investors may want to approach the current turmoil from a different perspective, and focus instead on these three investing strategies.

Consider minimum volatility funds

As their name implies, minimum volatility funds are explicitly designed to help mitigate the impact of market gyrations through a focus on less volatile securities. The approach, by design, is overweighting securities that exhibit less volatility. These are often companies with more stable earnings streams that may hold up better, on a relative basis, during market downturns.

Consider the quality theme

Investors may also want to consider adding quality to a portfolio, either through an Exchange Traded Fund (ETF) or active fund focused on companies with the following characteristics: earnings consistency, high return-on-equity (ROE) and low leverage. Historically, companies with these â€œquality” attributes have tended to perform relatively well during periods of rising volatility. In particular, quality companies have typically outperformed momentum names, a popular theme in recent years, when market volatility is elevated and rising.

Consider less traditional asset classes

Finally, investors may want to consider broadening their definition of stocks by moving “up the capital stack” toward preferred stocks. While they don’t provide the same upside potential as common stocks, U.S. preferred issues may provide less volatility.

Most preferred issues tend to be banks and other financial companies. Following massive regulatory changes in the financial sector, the U.S. banking sector is considerably less leveraged and arguably safer than it was pre-crisis. So, while more boring than they once were, U.S. financials may be well positioned to potentially provide a dividend stream.

To be sure, the above strategies aren’t likely to produce massive, double-digit returns. Investors looking for more aggressive profits probably need to test their nerves and try to time the market bottom. For the rest, a better approach may be seeking more modest returns with lower volatility, via a focus on portfolio construction, risk exposures and less traditional asset classes.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

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