For Equity Investors, the Best Defense Is a Solid Offense

Volatility in the markets might send some investors packing for safe havens, but in the long run those refuges might not be all that secure.


Volatility often compels investors to search for pockets of safety in the markets. At the same time, though, beware of following crowds to popular safe havens.

Piling into crowded trades can be risky, as a change in sentiment can send everyone running for the door at once. Yet equity investors, spooked by fears of recession and volatility in China, for the past year or so have been prompted to flock to sectors perceived as safer.

The utilities and consumer staples sectors have become such popular refuges from volatility that their valuations have risen to elevated levels. That doesn’t mean investors shouldn’t buy stocks in these sectors. But we at AllianceBernstein believe that it’s important to be selective by focusing on fundamentals to identify the most attractive opportunities.

So what should investors do? When there is heightened uncertainty in the market, we believe that it can be effective to invest in a barbell portfolio, which balances between exposure to high-quality, less cyclical stocks and exposure to some cyclical stocks that have solid fundamentals.

Just a few months ago, this approach was shown to be a good way to invest, as fears of a downturn dominated market sentiment. Recession concerns have since receded, however, as several positive forces continue to support the U.S. economy. These include record-low interest rates, consumers’ strong household free cash flow and wealth, a healthy banking system, a weakening U.S. dollar and stabilizing commodity prices. As a result, we believe that it’s a good time to shift toward the more cyclical side of the barbell by increasing exposures to high-quality companies within sectors such as industrials, energy and financials.

It’s also important to maintain some carefully chosen defensive positions as an insurance policy, in our view. In the health care sector, for instance, because of the continued concerns of drug-pricing pressures investors can find high-quality stocks with promising long-term growth prospects at attractive prices.

For investors seeking a more defensive solution, a portfolio that manages equity market exposure by taking long and short positions may help provide support during tough times. In 2008 long-short equity managers, as represented by the HFRI Equity Hedge index, provided investors with a degree of protection from the movements of the overall market. That year the average long-short fund was down 27 percent, whereas the S&P 500 fell 37 percent. This type of portfolio construction can provide a solid defense for a deteriorating economy while also providing upside potential if a worst-case scenario is avoided and the economic recovery persists — or accelerates.

Nobody has a crystal ball to predict the future direction of the U.S. economy. But even if things do get worse, it’s important to remember that every downturn has different drivers. The early-2000s recession was caused by the dot-com bust. Capital investment in technology tumbled, and stock prices in the tech sector fell by a cumulative 59 percent over the following five years. Yet over that same period, homebuilding was the best sector in the stock market, as prices rose by a cumulative 544 percent. So if they can keep an open mind on economic conditions, investors can position effectively to stay with equities and avoid trouble spots during tough times.

A good defense for difficult markets can be built by following a disciplined strategy for the long term. Hiding out in the same places as everyone else may provide an illusion of security that won’t necessarily prove safe when markets shift from risk-off to risk-on mode. Instead, look to experienced investors who know how to create a balanced portfolio of companies with both solid long-term prospects and the ability to hold up well during a downturn.

Kurt Feuerman is CIO of select U.S. equity portfolios at AllianceBernstein in New York.

See AB’s disclaimer.

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