“May you live in interesting times,” is an expression that is very applicable to today.
International conflicts and terrorism continue to escalate while world economies rapidly slow down. We are seeing corporations see their revenues and earnings erode, quarter after quarter. Revenues have been down four straight quarters and it looks like we are heading towards a fifth. Earnings have been down three in a row, with a fourth imminent.
Stock markets are at historical high levels, as you will see on the next chart, where cyclically adjusted price earnings are used. This is a great gauge on how expensive the market is and was developed by Professor Robert Shiller of Yale University and it does not bode well for stocks moving forward.
Historical peaks in the CAPE ratio has been between 20 and 27. Today, we are at the upper end of that range, at 26.21. The only deviation was in 2000 where there was the technology craze and markets traded to levels that made no sense. We believe that was a once in a lifetime phenomenon.
So if markets are at risk, how does one invest today?
First, it is critical that an investor changes their expectations for returns. In difficult periods, the focus should be on return of capital, not return on capital, together with more modest returns. We are at the tail end of a seven-year cycle, where the types of investments an investor should hold dramatically shifts. We note our current seven favorites below.
1. Utility ETF
Buy symbol IDU: iShares US Utilities, on NYSE
Why buy: Late in a business cycle, investors should shift their growth end of their portfolio to defensive sectors. These sectors have steady earnings and are boring but do not see a crash in their earnings during difficult economic periods. Utilities is one of those. Money tends to flow, especially institutional (exps. hedge funds, mutual funds) monies who drive the markets, to safer sectors who have good dividends and steadier earnings.
Details: IDU offers a very solid 3.68% dividend yield, excellent liquidity meaning it can be easily bought and sold, is in a conservative sector, and has a relatively low management fee (MER) of .43%. That is significantly lower than mutual funds. It is made up of 60 utility companies, with 58% of them being electric utility companies, and the majority of the rest being multi and gas utilities.
2. High Quality Bond ETF
Buy symbol IEF: iShares 7-10 Year Treasury Bond ETF or TLT: iShares 20+ Year Treasury Bond ETF
Why buy: Bonds tend to outperform as equity markets fall. Interest rates are exceptionally low, but on a comparable basis, are still actually high compared to much of the developed world including much of Europe and Japan where bond yields are near zero or in some cases, negative. We believe investors should only have the highest quality bond ETF’s as we anticipate that we will get an increasing number of corporate bond defaults in a weak economy. Also, lower quality bonds will actually see their prices fall, as money flows to safer havens, including US treasury bonds.
Details: Both ETF’s goal is to achieve bond market returns relative to their mandate. This means the 7 to 10-year treasury ETF goal is to achieve returns for bonds of that duration. The 20+ year treasury is a long term treasury bond ETF. The difference is that the longer term bond ETF has more leverage up and down. The price will go up more if interest rates fall versus terms of shorter duration. Of course, the same occurs in reverse. Both ETFs charge a low 0.15% MER, with IEF currently having an annual payout of 1.80% and TLT at 2.38%.
3. Cash or a high quality cash equivalent
Buy option: treasury bill
Why buy: This may sound like a strange recommendation given we are saying that you should invest in a vehicle that pays less than 1% per year. The reason is simple, at times return of your capital is more important than return on your capital. If we go through another significant correction or a crash like in the early 2000’s and 2008-09, those holding cash did great. The cash they had could buy a great deal more after stocks fell, then prior. It is not critical to always be invested as the industry wants you to think.
Details: Wherever you invest, make sure that you had Federal Government insurance to cover any bank failures. This is where we believe that owning government treasury bills may be the best option, as they are unconditionally guaranteed by the government. If you do purchase money market funds, make sure that the security inside is the highest quality, as even money market funds can fall in price if they have defaults on some of their underlying securities in their portfolio,
4. Consumer Staples ETF
Buy symbol XLP: Consumer Staples Select Sector SPDR ETF
Why buy: Again, this is another sector that performs well in late cycle investing. When stock markets are at peak or rolling over to the downside, the best sectors tend to be utilities, healthcare and consumer staples. The latter is important as the earnings of the companies in this sector tend to be less volatile as they sell goods that all consumers need, in good times and bad.
Details: The sector includes companies that sell household products and food and beverage staples. Again, products that everyone needs in boom times and periods of recession. The sector is considered a safer haven in volatile markets. XLP offers a solid 2.36% dividend and a low total expense ratio of 0.14%. Procter and Gamble and Coca Cola are its two biggest holdings, being just over 20% of the sector. The sector has 37 companies overall.
5. Healthcare ETF
Buy symbol XLV: Health Care Select Sector SPDR ETF
Why buy: As we stated above, another sector that tends to hold up better during difficult periods is the healthcare sector. It may prove to be somewhat more volatile than utilities or consumer staples, but again, during difficult periods, people still need health care. It is considered another safe haven sector.
Details: The healthcare sector includes a number of sub-sectors including pharmaceuticals; biotechnology; life science services; and healthcare providers, equipment and technology. The former two are the bulk of the companies with over 60% of the total. The two biggest holdings are Johnson & Johnson and Pfizer.
6. Gold ETF’s
Buy symbol GLD: SPDR Gold Shares or GDX: Market Vectors Gold Miners ETF
Why buy: There are a number of reasons to consider having gold as a component in one’s portfolio during market downturns, especially in today’s world. First, gold is the oldest currency around, and in a world of fiat currencies, which are only guaranteed by their underlying government, gold looks to be a safe haven. Also, in a difficult period, the Federal Reserve may have to resort once again to quantitative easing programs, which lowers the value of the dollar and makes gold that much more attractive. In essence, gold is a hedge against an unstable fiscal and monetary environment. You can either own gold itself via the GLD ETF or senior gold companies through GDX.
Details: SPDR Gold Shares (GLD) are intended to offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold, and to buy and sell that interest through the trading of a security on a regulated stock exchange. GLD has no dividend and an expense ratio of 0.40%. GDX, on the other hand, tracks the broad movement of companies within the precious metals sector. GDX has 35 holdings, with none representing more than 7% of the ETF. It has a yield of 0.58% and expense ratio of 0.53%.
7. Quality International Preferred Share ETF
Buy IPFF: iShares International Preferred Stock ETF
Why buy: Preferred shares are a great product for dividend income, with this international preferred share ETF providing a very high yield over 6%. It is also a way to hedge out of the US dollar for some of one’s funds, as all preferred shares in the portfolio are non-US. Preferred shares will always be less volatile than common stocks and tend to move up and down with interest rates. If interest rates fall, good quality preferred shares go up in value, providing potential for a capital gain on top of the dividend yield. There is some creditor risk but it is mitigated by the many positions in the portfolio.
Details: IPFF is a passive ETF that seeks to replicate S&P International Preferred Stock Index. The index measures the performance of a select group of preferred stocks from non-U.S. developed market issuers and traded in non-U.S. developed market venues. It offers a very solid yield of 6.12% with a management expense ratio of 0.55%. The fund has many positions with the largest being just over 4%, simply meaning it is well diversified and is cushioned if a few positions have challenges. This list provides a good cross section of the types of investments an investor should own in down stock markets. Given the risks in the market is significant today, it would be prudent to look closely at these securities as safe areas to invest.
For further information you can visit www.fortrusfinancial.com.
About the Author: Matthew Sammut is the Founder of Fortrus Financial Inc.