Playing Defense in this Market
There’s been a lot of volatility in the market recently, which makes it a great time to take a look at defensive plays.
By Louis B Llanes, CFA CMT
Founder, Wealthnet Investments, LLC
We've seen the markets come down pretty hard lately and many are wondering if the stock market is due for a correction or the possibility that we're closer to the end of the cycle. We don't know definitively that's the case but there are indications that we might be a lot closer.
Basket Trading – How Does It Work?
Increasing portfolio diversification in a volatile environment can be helpful as the market heads lower. In this article, I’m going to discuss adding a basket of instruments that can potentially add value now. Basket trading is when we have a group of investments that are put together and we trade them as a single unit and we customize the basket.
Basket I - Defensive Stocks That Have Bucked the Trend
The first basket I want to discuss is a group of defensive stocks. These are companies that have business models that are likely to do well even when times are bad. It’s also ideal to find stocks that are very liquid and allow us to be able to trade in and out of them without a lot of impact costs because we want to be able to be nimble with this basket. Lastly, we want to see that these stocks are bucking-the-trend and doing well as the markets are going down.
Basket II – Metals With Low Correlation to the S&P 500
Basket number two is a metals basket. This basket includes four different metals and each one has a different role. There are two types of metals in this basket – precious and non-precious. The precious metals include what you normally think of – gold and silver. The non-precious metals are less economic sensitive industrial metals that are non-correlated to the market.
A Look at the S&P 500 During the Recent Downdraft
The graph below shows each individual stock weighted by its market capitalization in the S&P 500 over the last three months. You can see which stocks are gaining value over the last three months as the market has come down and which have been losing value and you can also see size. This is important because we want to have liquid stocks. What you notice here is that you've got some of the big names getting hit hard. The bottom left corner is Amazon, about as big as it gets, taking it on the chin and losing money. That type of company is what we’re wanting to diversify away from, trail and trim back, and look for other places to put money. Not that you should completely get rid of these stocks entirely but diversify.
If we look at the green sections of this chart, we see companies like Philip Morris ($PM), Verizon ($VZ), Procter & Gamble ($PG), McDonald’s ($MCD), and Walmart ($WMT) that are benefitting from this decline. These companies have a record of financial strength and profits. They’re also less economically sensitive. These companies may be stronger in a decline because people are still going to go through the drive-thru, use their cell phones, and buy soap along with other essentials.
Defensive Basket Performance
This chart shows the actual performance of the defensive stock basket. The graph is the weighted average price of the five companies we covered previously – McDonald’s, Philip Morris, Verizon, Procter & Gamble, and Walmart.
At the beginning of the year, we saw that these defensive stocks started to camd down as technology stocks rocketed higher. Investors were shunning the defensive stocks and buying the tech. We then saw a bottom in May and what appears to be a variation of a “reverse-head-and-shoulders" technical pattern which traditionally is interpreted to be bullish.
The bottom section of the chart is a relative strength chart, which is showing how this basket is doing relative to the S&P 500. You can see a very strong breakout in October as the market came down. These stocks began to significantly outperform during the recent break.
Metals Basket Can Be an Aggress Counter Trend Diversifier
The metals basket has a similar profile, but it's more aggressive and volatile. Our metals basket broke downtrend and moved higher with positive relative performance and is near highs. This is in sharp contrast to the S&P 500 which lost steam.
A View of the S&P 500, Defensive Stocks, and Metals Together
In this chart, you can see the S&P 500, defensive stock and metals baskets all together. You’ll notice as the S&P moves downward, defensive and metal stocks move up. This is a confirmation that these baskets are behaving in a counter-market trend fashion which is exactly what we to see because it confirms the potential to profit if the trend continues.
Building and Weighting Baskets
Let’s review what’s in these baskets and how we weight them. First, the metals basket, which is weighted by volatility and correlation. We select the most attractive metals that we find in our research and then weight them and compare their volatility. For example, if gold is less volatile than other metals, it's going to have a higher weight and vice versa. The idea is that we want to have a weighting scheme that will give each holing a similar contribution to portfolio results. We’re not trying to make a bet which one's going to do better – instead, we assume they all will have the same Sharpe ratio. This allows us to construct a diversified portfolio only, and not forecast the benefits of any constitunet in the basket over the other based on return expectations. We're just trying to get a diversified portfolio. We take the volatility and correlation into account in order to make a solid basket.
The same process was done with the defensive stock basket. You’ll notice that the companies that were chosen are in different sectors and industries – that’s by design. We want to have different drivers of returns so that we get better diversification. Looking to the right, you’ll see the weightings, which aren’t equal and are based on the correlation and the volatility.
Now that we have our two baskets, we want to make this a singular trade, by blending them together in a way that enhances a stock portfolio. What this table below shows is the correlation matrix that shows historical co-movements (I.e., correlation) of each individual constituent inside the baskets.
What you want to see – and what we do see – are low numbers. The only relatively high numbers that we see are the Gold Trust and Silver Trust, which tend to move together. The rest of these are moderate to low, so we feel good about what we have in this basket.
Now we want to put those two baskets together based on the same type of analysis. We look at the daily and quarterly volatility of the metals basket as a whole and the defensive stock basket as a whole, then we put them together. The final result is a basket weighting of 55 percent in metals and 45 percent in the defensive stocks.
Now the question is how much do you put in these baskets? That depends on your risk profile. For example, if you're very conservative and you're risking .5 percent per trade, you would put 3.7 percent of your portfolio in metals, 4.4 percent of defensive stocks.
Rising Optimism and Elections
The biggest risk we see in owning these baskets is a rising market. If optimism comes back strong these baskets could lag in performance. We’re also going into the election cycle and typically the market will be weak before the election and strengthen after elections are over through the end of the year. If that happens again, then we're likely to see losses in these. This is something to keep your eye on and position size accordingly.
Defensive stocks and metals should be a part of a stock portfolio in today’s environment. Investors can scale into these custom baskets on pull backs in order to better diversify portfolios. We see this type of trade in the context of a 3 – 6-week time frame. Counter trend trades tend to be shorter-term because the markets generally have shorter bouts of downside volatility compared to upside movement.
Our analysis indicates upside potential profits of 21 percent in the metals basket, which is good if we have a negative stock environment. The defensive stocks could also move up about 13 percent.
Again, there are risks involved – the market could rally and we also see downside risks from the volatility of these instruments of 13.7 percent in the metals basket and 11.3 percent in the defensive basket. As always, trade in line with your own investment objectives and what works best for your portfolio.
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