Zero rates and a bull market have been replaced by volatility and rising rates. Where should investors look now?
TAG Chief Investment Strategist, Jeff Tumolo, believes markets have entered a transitionary phase.
Highlighted by volatility in stocks and bonds, Federal Reserve interest rate tightening to counter historic inflation, Fed balance sheet rightsizing, and geopolitical instability, we are likely in the midst of an investing paradigm shift.
The relatively easy money made over the past decade, spurred by near zero interest rates and a bull market, is a thing of the past. It was fun while it lasted, but it was never going to last forever.
Finding Alpha in this market will require a lot more thought and focus. But there will be opportunities for those with both the conviction and the stomach to accept higher volatility.
The current broad based selling pressure in both the stock and bond markets is creating higher systemic risks in the short term while also creating attractive opportunities for select long term investment. Though much of this market volatility was anticipated, and portfolios managed accordingly, there are several areas to look at for opportunistic investment going forward.
Absolute return in place of fixed income. As it relates to the rising interest rate environment, TAG has long been a proponent of allocating to Absolute Return Strategies as an alternative to fixed income investments. This is precisely the type of volatile environment in which one should be increasing allocations to low market exposure arbitrage related strategies. These strategies have demonstrated very little correlation to interest rate increases. Additionally, volatile equity markets have largely improved the opportunity. Specifically, macro trading strategies and volatility arbitrage strategies have been able to generate strong returns in the current environment.
Hedged equity investing. Managers that invest on both the long and short side can profit from sharp irrational movements in individual stocks, while generally maintaining lower overall net stock exposure.
CBOE Volatility Index since Nov. 1, 2021
Bloomberg
In particular we use a number of market neutral managers (those that place equal weight on long and short investments) who have performed well in this environment. Further, deploying new capital to structured trades which buy equity index funds but overlay hedges can help mute the impact of any further declines while preparing the portfolio for an eventual sustained market rebound.
Equity Sector Performance Year to Date
Sector and quality focus. The severity and speed of capital market declines this year have resulted in broad and indiscriminate selling of nearly all assets. The relative value of the S&P 500 index as represented by earnings has declined from 23 times expected earnings to 17 times as of May 31.
But this does not necessarily signal a discount on all stocks. Not every company or industry will be impacted the same way. In the short run, higher levels of aggregate daily price volatility have pulled down the prices of high quality assets along with those of lower quality assets. There are many companies whose cash flows will not be sustainable in the future and there are real reasons to reprice these securities lower. For example, Growth stocks, as represented by NASDAQ and Russell 1000 Growth Index, are down 40%-50% from peak levels.
At the same time, there are companies whose long-term prospects have not changed materially. These are companies, industries, and areas of the capital markets where price dislocation has created attractive investment opportunity. One example is regional banks, which can benefit from rising interest rates, and have substantially less exposure to geopolitical risk, investment banking fees and capital market trading revenue than their global bank counterparts. Additionally, certain cash flow positive, fast growing software companies may have been unduly punished in the recent market turmoil. Thoughtful investors will be able to find opportunities even in the face of increased economic uncertainty.
As it relates to multiple compression in equity prices and movement toward higher quality cash flows, we believe that a movement toward dividend paying stocks is prudent. The severe gyrations in stock markets can provide an opportunity to gradually move equity allocations to higher quality higher dividend stocks.
Allocation to cash. Marginal increases in cash and lower risk strategies can provide a more stable portfolio in the short term and also allow investors to move methodically into new investments. With a properly balanced allocation, investors can be in a position to not only ride out the current market declines, but to incrementally take advantage of price dislocations that current and future broad based asset sell-offs will create.
Market volatility is likely to continue in the short-term, at least until the interest rate environment has stabilized at higher levels. Economic uncertainty will also continue to contribute to asset price volatility until the future prospects of higher inflation and/or an economic recession have been resolved.