The Independent Market Observer

How Do You Position a Portfolio for Uncertainty?

Posted by Chris Stuart, CFA

This entry was posted on Aug 20, 2020 4:00:11 PM

and tagged Commentary

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uncertaintyBrad here. With so much unknown in our world, it seemed the perfect time to discuss how to position a portfolio for uncertainty. Today, Christ Stuart, a senior investment research analyst on our Investment Management and Research team, will do just that. Take it away, Chris.

One of the consistent themes this year has been uncertainty. In fact, in the modern era, we haven’t dealt with uncertainty of this magnitude, one that has had a direct effect on the health and well-being of our citizens. Further, the effects of the coronavirus have been magnified by the perception of a disorganized governmental response and how it might severely affect our economy.

As for the markets, it seems we reached peak uncertainty in March. Still, as we move through August, much remains unresolved:

  • Will a successful vaccine be developed this year?
  • Will this vaccine provide lasting immunity?
  • Will states have to shut down again?
  • Do we have enough testing?
  • Will children go back to school in the fall?
  • Will companies lay off more employees to compensate for lost business?

Given these worries, many advisors are looking for ways to position portfolios during this crisis. Some of their clients would like to take advantage of the volatility, while others are concerned about the increased risks that this pandemic has introduced to their portfolios. So, how can we help investors plan for these sorts of uncertainties?

It won't be easy

In my 20+ years as an investment professional, I can't recall another time when I was so unsure of what the future held. In the financial crisis of 2008–2009, it was clear there would be casualties. Still, in early 2009, the opportunities for beaten-down equities became overwhelmingly apparent to me.

In March 2020, I also recognized some opportunities in stocks that had fallen by more than 50 percent. But I didn't have the same sort of conviction—especially for those companies taking a direct hit from the coronavirus (namely, the airlines, cruise liners, hotels, and casinos.). While many of these companies have bounced significantly from their March lows, questions remain about the health of their operations moving forward.

Yet we must remember that the markets would have minimal volatility if there weren't some level of uncertainty. As uncertainty rises, so does the panic and volatility in the equity markets. Often, this panic and uncertainty lead to some of the best opportunities for equity investors. Thus, as the saying goes, “the time to buy is when there's blood in the streets.”

What’s the scenario?

In terms of where we go from here, it’s really anybody’s guess. Personally, I like to think in terms of different scenarios when trying to navigate uncertain markets. Below are two scenarios to consider. Note, I’m not implying either of these will be the definitive conclusion to this pandemic. Rather, this is a useful exercise for thinking about what the future might hold.

Scenario 1: The world changes permanently, and we all need to adapt. I’ll admit this is a rather doom-and-gloom, worst-case scenario, but let’s just say the coronavirus is here to stay. Maybe a vaccine is developed, but it doesn’t provide long-lasting immunity. Many continually get sick each year, due to various mutations in the virus. This ongoing situation leads to continued reductions in travel and long-term implications for many leisure-based businesses. In this scenario, investors continue to bid up high-growth technology or "work from home" beneficiaries, which would likely continue to thrive in this sort of environment.

Scenario 2: Continued regional outbreaks, re-closures of varying degrees of activities within states, but vaccines and antibody treatments are developed. In this scenario, the vaccines provide long-lasting immunity, and cases dwindle by mid-2021. As a result, there is a boom in leisure-based businesses that have been able to weather the storm up until this point. In this scenario, work from home stocks that haven’t seen a definitive long-lasting effect likely see some pressure.

The bucket strategy

With a portfolio of equities, we can think about these two scenarios and bucket our stocks to help define a portfolio’s risk. Based on the scenarios described above, there are a few buckets that may be appropriate.

  • Bucket 1: In this bucket, we could include work from home beneficiaries (e.g., video conferencing, video games, grocery delivery), which will likely outperform in Scenario 1 but could be pressured if we see more of a V-shaped recovery.
  • Bucket 2: Here, we could include those stocks with significant exposure to extended coronavirus shutdowns, but with high risk/high reward (e.g., airlines, banks, hotels, brick-and-mortar retail, restaurants, commercial REITs).
  • Bucket 3: In this bucket, we would have stocks from companies not directly affected by the coronavirus but could experience secondary effects via extended closures (e.g., software companies, sales-based businesses, car dealerships).
  • Bucket 4: In the last bucket, include those companies with limited coronavirus economic exposure that are able to navigate any significant economic headwinds (e.g., consumer staples, home improvement, utilities).

A bucketing strategy like this one can help focus in on any outsized risks within an equity portfolio. For example, at the height of the COVID damage back in March, those companies that faced forced closures (e.g., airlines, restaurants, and casinos) were also those that sold off the most during the market meltdown. At the time, a bucketed approach may have helped balance a portfolio across the COVID risk spectrum. It would also allow you to assess any problematic names and perhaps opt for those companies that might have more flexibility to navigate any turbulence.

As another example, in March, there were some publicly traded car dealerships that seemed like they could be heading for extinction. Some investors might have panicked and sold all their shares. But if they explored this bucketing exercise and realized that they didn’t have significant exposure to the highly exposed COVID industries, they might have been able to avoid selling shares. To be sure, used car sales have improved significantly in recent months.

Balance and diversification

There are likely still opportunities among the deeper-value, highly exposed COVID names that have run up significantly since March (although it might turn your stomach a bit to take a position). A prime example of this is the cruise ship industry. Despite a big bounce in the second quarter, the industry is still down, on average, roughly 70 percent across the board this year. But I’m confident that at some point in the future (although I don’t know when), the cruise industry will be fully operational. Is it going to take a few bankruptcies among the big U.S.-based cruise companies to get there? Maybe so.

Thus, I think the key to planning for uncertainty is balance and diversification. Of course, there is no clear-cut defined percentage within each bucket for every investor, as everyone has a different level of risk tolerance. But the bucketing strategy will give you some ideas to try and evaluate your exposures and overall risk levels within equity portfolios.

After examining a portfolio, you may realize that 100 percent of the stocks are significantly exposed to COVID-19. If so, it might make sense to try to diversify into stocks or industries that are better equipped to navigate any extended effects of the virus.

Understand the risks

Uncertainty can be quite scary when investing. But understanding the risks and taking advantage of the volatility derived from the uncertainty can often be a winning proposition. If I can leave you with one thing to remember, it’s this: don’t put all your eggs in one bucket.

Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.

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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

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