As stock market volatility continues to show evidence of underlying uncertainty, many investors are looking for ways to protect prior returns during the next downturn. In these types of environments, investors will generally turn to the traditional safe havens. For the equities space, this includes industry sectors like health care, consumer staples, and utilities.
But recent trends suggest that the typical safe haven investments may not be the way to go this time around, as the next economic downturn could weigh heavily on the market’s most overvalued assets. Alternatively, exposure to the gold/silver trade or long positions in U.S. treasuries could be preferable given the extremity of the recent market trends impacting valuations.
The Chicago Board Options Exchange Volatility Index, or VIX, is generally used to gauge the level of fear present in the market. Essentially, the VIX is a statistical measure of the potential price fluctuations which may be found in the S&P 500 Index option (SPX) during the next 12 months. The spikes we have seen during several occasions this year suggests that the optimism may be coming to an end for the longest bull market run in history.
If a true economic downturn is coming, investors will need to locate undervalued assets in order to gain a more protective stance. The health care sector is currently trading at elevated levels (18.2x TTM earnings), while the utilities sector is trading at 17.1x TTM earnings. The consumer staples sector does not look quite so overextended (at 15.1x TTM earnings) but a broader decline in equities suggests that this may not be a viable strategy for defensive investors.
In this case, investors may consider adding exposure to the gold/silver trade or adopting long positions in treasuries. Strength in these strategies may stem primarily from the extent of the prior bearishness in both areas of the market. Gold prices have fallen by more than 36% since they reached record highs in August 2011. The S&P 500 has gained nearly 150% over the same period, and these divergences mark extreme relative to the historical averages. This could make precious metals more attractive in the event of another downturn in the market.
Profitable strategies may also be found with trades going long government bonds (given their low historical correlations relative to stocks). Treasuries can offer portfolio protection during an economic slowdown as drops in inflation raise the purchasing power of an investor’s bond payments. In this type of scenario, we can reasonably expect the market to move back into bonds with greater fervor (which could easily drive prices higher from current levels).
Many investors use bonds as a way of generating a steady income stream, since a bond’s coupon payments are guaranteed, but they can also be used to reduce overall risk within your portfolio. When equities begin the next cyclical downturn, inversely-correlated bond instruments offer attractive diversification possibilities which can dampen volatility risks, reduce the potential for capital gains losses, and actually produce gains given the dominant trends currently visible in the market.
Article By: Ric Cox
