Be Prepared for Turbulence
Originally posted at Briefing.com
The equity market has enjoyed a smooth flight path since the start of the year, climbing to elevations last seen in October 2007. That steady climb has fostered a sense of complacency that nothing can go wrong with the Federal Reserve piloting the flight.
Recent changes in the air current, however, have created some turbulence that has disrupted the market's otherwise confident flight demeanor.
The thing is, the turbulence has been on the market's radar since the start of the year, so it's not like it has been totally unexpected. Just like flying, though, one never feels truly unsettled about turbulence until the plane starts to shake and bump.
Once that happens, complacency soon shifts to a feeling of anxiousness about being so high off the ground and not having any control of the situation.
The flight analogy is applicable for investors in today's market with one exception. Before things start to shake and bump, and even when things are shaking and bumping, investors still have the ability to control things in such a way that can reduce that anxious feeling when turbulence hits.
Some of those strategies to guard against downside risk were highlighted in the Market View we published in mid-December. In brief, they include:
- hedging through the use of options
- reducing exposure to high-beta stocks
- favoring stocks in countercyclical sectors (eg. health care, consumer staples, utilities, and telecom services)
- owning companies with strong balance sheets and the capacity to increase dividends in any environment
- buying shorter-duration bonds and
- raising cash
Any or all of those strategies might have been helpful in the latest week.
Last week, the S&P 500 suffered its worst day of the year, declining 1.2% on Wednesday.
That decline happened to coincide with the release of the FOMC Minutes for the January meeting in which it was noted "a number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred."
While the context of that view was nothing different from what was heard in the Minutes for the December meeting, the overblown spin was that it was a hawkish signal that the QE spigot will be closing sooner rather than later. Naturally, the selloff that gained steam 45 minutes after the release of the Minutes was attributed to concerns about the meaning of the Minutes.
We didn't buy into the idea that the Fed is starting to lean more hawkish. Our sense of things was validated Friday when St. Louis Fed President Bullard told CNBC that such ideas are a natural thing to be talking about and that, "Fed policy is very easy and it's going to stay easy for a long time."
What struck us, though, is how quickly the market's perspective shifted after that turbulent selloff on Wednesday. All of a sudden, the market went from complacent to angst-ridden about:
- Quantitative easing coming to an end
- The Italian election
- The March 1 sequestration deadline
- Weak first quarter guidance
- Efforts by China to slow its economy
- The eurozone remaining in recession
- The payroll tax hike and high gas prices hurting consumer spending
- A major stock market correction being at hand
The CBOE Volatility Index soared 19% on Wednesday, commodity prices tanked, the dollar surged, bond yields fell, and every sector in the S&P 500 ended with a loss (countercyclical sectors fell the least).
By Friday, however, the stock market looked like it was on auto-pilot again. Aided by Mr. Bullard's clarification, the S&P 500 increased 0.9%.
The S&P 500 still closed lower for the week -- the first weekly loss this year -- but only by 0.4%. Not exactly a huge air pocket considering it had been up 6.7% since the start of the year entering the week.
Keep Your Balance
No one can say for certain what's in store for the stock market. Our message throughout the rally has been to participate in it in a balanced manner, appreciating both the trend and the importance of risk management in riding that trend.
Shifts in sentiment can happen quickly and stock prices can move sharply as a result, altering the trend in a meaningful fashion.
We have heard of course all year that this is a "risk-on" market.
Well, it is clear more risk is being taken, but "risk on" may be stretching it considering the defensive-oriented consumer staples and health care sectors are the best-performing sectors year-to-date with gains of 9.4% and 8.4%, respectively, followed by the financial (7.9%), energy (7.6%) and industrials (7.6%) sectors.
That grouping fits well with the message in our Market View that, with regular mood swings expected, a blended investment strategy made sense entering 2013.
That is, we weren't suggesting overweighting or underweighting cyclical or countercyclical sectors exclusively since a balanced mix would allow for participation in upside moves and would help mitigate losses in down markets.
At the same time, we also said that we saw value in total return strategies and that dividend-growth stocks looked appealing for their income-generating potential.
What It All Means
The market ran into turbulence last week. Many pundits were making unsettling predictions as soon as it did. They may be right, but no one knows for certain what the future holds.
If you were able to drown out the noise of the last week, you would have also heard that a number of companies raised their dividend, undaunted by all of the noise because they had the financial wherewithal to do so.
The table below lists some of the more notable companies that raised their dividend last week.
Companies that pay a dividend are not bullet proof. Their stock prices could be hit for any number of reasons and the ensuing capital loss could easily exceed the value of the dividend that gets paid.
Nonetheless, the income provided by dividends is still income that can be reinvested in the stock or spent for other purposes. When a stock that doesn't pay a dividend goes down in price, investors get nothing in return -- except maybe a tax-loss asset.
We bring this to your attention, because the benefits of owning dividend-paying stocks can never be overstated. As shown in our January 22 note, "S&P 500 Is, Like, Totally at All-Time High... Totally," there is a huge performance gap between the S&P 500 Total Return Index and the S&P 500 Price Index.
There is added meaning, therefore, in saying dividend-paying stocks pay dividends for investors. They do so in up markets, down markets, sideways markets, and, as we saw last week, in turbulent markets.
Coca-Cola, Kimberly-Clark, and Wal-Mart have seen their share of bumpy flights, but each of those companies has increased its dividend for at least 25 consecutive years. They are known as Dividend Aristocrats and there are 51 other companies with a similar label, many of which yield more than the 10-year Treasury note.
When things start shaking and bumping, as they might in coming weeks, there will be less angst about the turbulence when you have companies like that in your investment portfolio that can produce income for you and are capable of raising their dividend in any environment.
About Patrick O'Hare
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