The Banyan Market Letter
Risk On — Risk Off!
by MIKE BURNICK on May 25, 2011 Issue 18
In recent years, financial markets have been characterized by a split personality.
Risk-on trades ... in which nearly every asset class rallies together, particularly higher beta investments (commodities, stocks).
Risk-off trades ... by contrast, feature a flight to quality (US dollar, Treasury bonds) during periodic bouts of risk aversion by investors.
Recently, we have witnessed investors inching back into the risk-off camp.
US stocks declined modestly again last week — the third straight week the S&P 500 slipped lower. And the correction has continued this week as domestic markets followed Asian and European stocks lower. Not surprisingly, higher beta asset classes that are perceived as higher risk, especially commodities and resource-related stocks, have taken the brunt of the selling pressure in recent weeks.1
Still, the correction so far is a mild one. For example, the Dow Jones Industrial Average is still up 6.8 percent year-to-date while the S&P 500 is hanging on to gains of 4.8 percent. And it’s worth noting that even after the recent slide, the Dow is just 3.4 percent below the multi-year high reached on May 2.2
A convergence of uncertainties is weighing on investor sentiment and rising market volatility is a predictable result. Here are just a few of the biggest concerns on investors’ minds right now ...
The ongoing European debt crisis: A nagging problem that just won’t go away ...
Taken individually, none of these uncertainties would seem to be enough to derail the global recovery or lead to a steeper market decline. However, collectively, these unknowns have a multiplier effect that could sap investor sentiment in the short run.
Financial markets hate uncertainty and when faced with numerous unknowns, it’s likely they will remain under selling pressure. The good news: When the uncertainties lift, so should the markets.
But for now, we expect markets to climb “a wall of worry.” We’ve seen this kind of action before. You don’t have to go back that far to remember that at this time last year ...
Volatility was on the rise while stocks and commodities were in correction mode following the flash-crash in early May 2010 ...
Also remember, in spite of these worries, markets zoomed higher after digesting this uncertainty in the second half of 2010. Let’s take a closer look at what’s driving the turbulence today...
A Stronger Soft Patch
A recent string of somewhat disappointing reports on the economy is contributing to the risk-off trades. In the near term, we expect these pressures to weigh on markets. Let’s face it, the economy is working through another soft patch — a temporary slowdown in the rate of growth. This is similar to what we experienced this time last year, but we expect this too will pass ... in time.
The good news is that now the economy appears to be in much better shape to handle this soft patch than it was a year ago. Let’s take a look at some hard evidence...
The graph (below) shows one of my favorite indicators, the US Weekly Leading Index (WLI), published every Friday by the Economic Cycle Research Institute (ECRI).3
The ECRI WLI captures an array of cyclical economic indicators specifically designed to predict shifts in the direction of the economy. One year ago, the index was in the midst of a steep decline, indicating a sharp slowdown in US economic growth.4
This time around, we see no such slump. While the rate of growth in the ECRI WLI has moderated recently, we find this is consistent with a temporary slowdown in growth, NOT a looming recession.
Next, take a look at the graph below showing the Eurozone Purchasing Managers Index (PMI); a key leading indicator of business sector activity in Europe.
With ongoing sovereign debt concerns still lingering, you might expect to see a sharp drop in this key indicators, but that’s not the case. The latest reading in May shows evidence of falloff in manufacturing sector activity, but the overall trend in the data continues to show robust expansion in the Eurozone economy.5
Our view is that the global economy is in transition as a rapid-growth recovery phase matures into a more sustained expansion. The rate of economic growth is bound to slow somewhat at this point and be uneven across different markets. That’s only natural.
Even though we expect the recent downshift in growth to be temporary, at Banyan Partners, we’ve been proactive in paring back our overweight allocation in some of the high beta sectors of the market and have been raising cash across most of our equity portfolios. You may want to consider doing the same. This is a good time to exercise some caution. Depending on your portfolio, holding 10-20 percent or more in cash reserves could be a prudent move with market volatility on the rise.
Plus, we’re employing other defensive strategies to help protect our clients’ portfolios.
Two Ways to Guard Against Downside Volatility
1. Inverse Funds & ETFs: Last week, we mentioned some specific tactical trades we’re making in our Global Fixed Income Strategy, including an inverse mutual fund that we feel may help protect our portfolios from a drop in bond prices. Also, since the risk-off trade came back into vogue recently, the oversold US dollar has been enjoying a bounce, presenting additional opportunity. As a result, we recently added a fund that’s designed to be a leveraged bet on the value of the buck. This could help protect the principal value of our income portfolios from volatile currency swings as well.
2. Tactical Stock Options: In addition to using inverse mutual funds and ETFs as tools to preserve portfolio value, members of Banyan’s investment team have spent decades fine-tuning stock option overlay strategies that we use in select client accounts as a further tactical measure against stock volatility.
For example, certain stock positions across our equity portfolios represent holdings we’re still very bullish on for the long term. So we may not want to sell too soon, especially if a sale triggers unwanted tax consequences. Rather than trimming our stock holdings, we may instead choose to sell covered calls to bring premium income into client portfolios. The extra income isn’t a perfect downside hedge, but can help cushion positions against a short-term pullback.
A recent case in point is health care giant Baxter International (NYSE: BAX). After a significant rally in April and May, BAX was trading almost 8 percent above its 50-day price moving average. Although the shares are somewhat extended currently, we still see further upside potential for BAX. So rather than taking profits on this investment prematurely, we sold covered calls slightly above the current market price and pocketed the premium.
The goal here is to bring several dollars per share of income into the portfolio, which may offer a cushion against short-term price volatility. Of course, these specialized stock option strategies have unique risks and certainly aren’t appropriate for every client. But where warranted and in certain circumstances, disciplined option overlay strategies like these may help protect an equity portfolio as markets encounter headwinds.
To sum up: While recent data tell us the global economy is slowing, our take is that this will be a temporary soft patch, instead of the end of the economic expansion. The important point to keep in mind is that periodic slowdowns like this aren’t uncommon ... it’s a normal and even healthy part of any business cycle. The key to weathering market volatility is being prepared.
After many decades of experience, the Banyan Partners investment team has been through these rough periods and we’re on top of this one too. Just last year, uncertainty triggered two corrections of about 15 percent, yet Banyan’s core equity strategy ended 2010 up, net of fees and trade costs.
As investors, we all recognize market volatility can happen at any time. But it’s always unsettling. And while a natural reaction can be to reduce or eliminate exposure to risky assets, sometimes these sell-offs present unique opportunities to take on new positions. If nothing else, corrections are great wake up calls to remind you to review your investments, making sure you have a formal strategy, which will make riding out the day-to-day fluctuations far less frightening.
Good investing,
Mike Burnick
Director of Client Communications
Banyan Partners, LLC
The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to any company, industry or sector mentioned in this report. The strategies mentioned may not be suitable for all investors. Past performance is no guarantee of future results. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.
Banyan Partners and the advisory accounts that we manage may have option positions and/or long or short positions in the securities mentioned in this report and may purchase or sell such securities without notice. This newsletter is not a complete analysis of every material fact with respect to any company, industry or security mentioned in this report. Please contact us for additional information.
Inverse and leveraged ETFs and mutual funds are highly complex financial instruments that may be utilized in pursuit of the Program’s overall investment objectives. Due to the effects of compounding, their performance over long periods of time can differ significantly from their stated objectives.
Options involve risk and are not suitable for all investors; investors. Certain option strategies require the establishment of a margin account. Margin borrowing adds risk to investments and is not appropriate of all investors.
1 Bloomberg market data, 5/25/11
2 Ibid.
3 Economic Cycle Research Institute, 5/20/11
4 Ibid.
5 Thomson Reuters, 5/16/11
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