As part of a series on Investment Strategy, we have been speaking to a broad cross-section of the industry to understand how advisers can protect portfolios in a difficult time for markets.
The S&P 500 is down roughly 20% from its all-time high in January, officially putting it in bear market territory. Indeed, the index ended the first half of 2022 with one of its worst starts ever.
Jim McDonald, executive vice president and chief investment strategist at Northern Trust said the most important thing advisers can do is make sure that clients “stay in their seats” with the plans they have got.
“These plans should have been built to withstand volatility, and probably the biggest mistake that can happen right now, is people making a major de-risking when the market is already down roughly 20% from its peak.”
Rather than radical de-risking, portfolios can be tilted to maximize returns from areas that are more suited to this kind of environment.
“We like real assets, so natural resources and listed infrastructure,” he added. “We think that those are beneficiaries of a sticky inflation environment, which is the number one risk case.”
McDonald also sees an attractive risk opportunity in high-yield bonds.
“We think of high-yield bonds as an alternative to a risk asset, we don’t think of them as an alternative to fixed income.
“High-yield bonds have about a third of the downside to equities and so as a risk asset, they are much lower risk than broad equity markets,” he said.
The valuation perspective
A key component of value investing is building in a margin of safety – purchasing a security when the market price falls below its intrinsic value – something that can be built into portfolios.
“You have to build portfolios that will allow clients to meet their spending needs over the longer-term,” he said. “If you have a current yield in hand of 8.5% on high-yield bonds, that gives you some margin of safety to help you ride through the economic softness.”
He explained that valuations often have little impact on 12-month returns, and in order to see a demonstrable relationship between valuations and returns, you would need to look at a period of over five years.
That said, areas that are displaying good discounts currently sit outside of the US, with Europe at roughly a 6% discount to historical p/e levels while the US is around an 8% premium.
This is also happening in the value and growth trade with value stocks trading at historical discounts and growth areas at historical premiums.
“We still think there is some room for value and that will probably, long-term, help ex-US stocks because they have a larger component of value than the US does,” he said.
After a bear market, a recovery
According to data from Northern Trust, bear market declines, on average, span 21 months and result in a 41% drawdown.
Cyclical bear markets tend to be shorter and more severe, but importantly Northern Trust’s data showed that one-year returns following 20% declines come in at 12%.
“After every recession, there’s a recovery and after every bear market, there’s a recovery,” said McDonald.
“Now, you tend to have a good stock market returns on average after that, especially earnings recovery – that always happens after a recession.”
The risk of a recession tends to bring out short-termism in markets, but McDonald warned against playing it too safe.
“If you’ve got your portfolio structure to get you through this volatility, don’t forget that things will improve,” he added.
“If you are too defensive when that recovery takes place, it’s going to be expensive.”
