Look to Unloved Sectors 

The idea: The US equity market has had a tremendous run in 2023, but much of the rally has been concentrated in the Magnificent Seven. In our mind, that means investors don’t have to sit out the equity market altogether but can instead rotate into sectors and countries that haven’t seen as much investor enthusiasm. These markets are generally cyclical, though, and carry no shortage of risk, particularly in the event a recession emerges. For that reason, we recommend pairing the exposure with a side of short-dated bonds.

The strategy: In the US, we’re most enthused about banks, materials, and master-limited partnerships (MLPs). (Note: there’s decent levels of small-cap exposure in these sectors) Of the three, banks likely face the greatest fundamental risk, given concerns about asset/liability mismatch and commercial real estate exposure. Our analysis suggests the selloff as the banking crisis emerged priced in at least some of that risk.

In materials, the sector has improved in quality while our proprietary valuation framework suggests it’s a relative buy next to pricier US sectors. MLPs are also a relative value story and have shown fundamental improvement through greater capital discipline, with the added benefit of a healthy yield.

There are attractive opportunities overseas as well, in emerging markets and select European markets like energy. Non-US exposure comes with currency diversification — not a bad thing should the Federal Reserve begin to lower rates. However, these markets aren’t meaningfully less cyclical than banks, materials, and MLPs, and court their own economic risks, particularly if there’s a global slowdown.

To offset concerns around added cyclical exposure, a short-duration Treasury bucket — maturities of two years and under — can give investors a yield of around 5% and the ability to opportunistically add to the cyclical exposure should volatility emerge.

The big picture: In 2022, valuations were improving but economic uncertainty was mounting. In 2023, much of that fear has dissipated, but valuations aren’t screamingly cheap. Our emphasis is robustness rather than market-timing or momentum.

Consider Korean Banks

The idea: Korea is a promising opportunity for investors, particularly in the financial services sector. The larger trend in this country and this sector is a movement toward loosening government restrictions on returning capital to shareholders. I believe there’s a chance for the share prices on some Korean banks to double over the next 18 to 24 months — and still be valued at similar or even lower valuations compared to banks in other parts of the world.

The strategy: Two companies that look promising are Korean banks KB Financial and Hana Financial. Normally when a bank sells at a 60% to 70% discount to book value, it is suffering from poor asset quality. That’s not the case in Korea, where loan growth has been low, so it’s not prone to the classic lending bubble during an overheated period. Mortgages are lent at conservative 50% loan-to-value ratios.

Investors have worried that management will do something silly with the excess capital banks have. Won’t they look for growth through overpriced acquisitions? Or take on too much risk to accelerate growth? Or, will the government force them to use capital in a way unfriendly to shareholders, in lending to weak industries to support export growth? The difference is that today, the industries that drive export growth are very healthy and the risk that banks will be asked to do something like that is a lot lower.

In this cycle, banks have gone to bat for shareholders with the government in asking for the ability to return excess capital through dividends and share repurchase. While the government told them not to return capital during the uncertainty of the Covid crisis, there are signs it is becoming more comfortable with bank capitalization. KB, for example, just announced a share repurchase program. 

The big picture: Korea’s population ranks in the top 10 on literacy and math education, and its companies have dominant positions in important industries like semiconductors and auto production, including production of batteries for electric vehicles. Korea’s economy will continue to be driven by its increased share of trade and the benefits of its strong education system, and that will help domestic income and consumption. The three largest Korean banks control 70% of the loan market and are very focused on loans to consumers and small businesses. 

Think Treasuries — and Gold

The idea: Stock valuations are still quite a bit on the high side, bonds have seen quite a big selloff, and monetary policy is tight. I think we’re going to look back on this period and say I wish I had owned more Treasuries. I don’t think that Treasury yields can get much higher than where they are now. We’re already at a level on the two-year Treasury right around the Fed funds rate, and if the Fed isn’t going to raise that many more times, we sort of cap out.

The strategy: When you look at what’s happened with the 10-year Treasury, yields have gone up. If we get a little inflation resurgence in late summer or early fall, you probably see those continue to stay high. I think the two-year is at a point where it has topped out or is close. The short end of the curve is very sensitive to what monetary policymakers are doing — the two-year Treasury or even the six-month Treasury is so high. What’s the worst that happens if you buy Treasuries at this level? You’re going to make over 5% in yield to wait to see how this plays out.

Gold is a play, too. Think about the environment we’re in — there’s been a lot of currency volatility recently. You have the Chinese renminbi and Japanese yen all over the place and a bunch of fear and uncertainty. Generally, the dollar has strengthened, which has made all the other currencies weaken.

The big picture: I think currency volatility is here for a while. Crypto had been the new-age solution to that problem, but that has sold off. It’s important to remember some of those tried-and-true methods for hedging against volatility like gold.

Limit the Losses

The idea: For diversified portfolios, I’ve been fascinated by the advent and usefulness of buffer exchange-traded funds — also called defined outcome ETFs — based on indexes like the S&P 500. It’s a way to take profits from recent market gains without exiting and making a complete market timing call. Just dial down your exposure and stay invested.

The strategy: Buffer ETFs are designed to limit losses in market downturns while still allowing investors to take part in a percentage of the market’s gains. Right now, if markets continue to march higher, I get dollar-for-dollar upside in the market with a reasonable cap [on gains] of roughly 12% to 14% over the next 12 months, which is below what most sell-side analysts have as the bull case right now.

If higher interest rates finally bite and markets fall 10% or 20%, the way these ETFs work is I get to skip the first 15% of the market downside. Assuming I hold the ETFs through their next reset date — they have 12- month time horizons — I am assured outperformance to the downside. For clients nervous about current market conditions, I say, “Let’s not sell and try to time the market. Instead, let’s take 30% of your equity allocation and invest in a buffered ETF.” If the market keeps marching higher, you capture 12% to 14% of that upside over the next year. If markets fall, you skip the first 15% of downside. If the market is down 20% you’re down only 5%.

These products are highly liquid, and since they are not structured products, there’s no counterparty risk. I use the FT Cboe Vest US Equity Moderate Buffer ETFs, so ETFs like GJUN, GJUL, GAUG and so on. At 0.85% in fees, they’re not as cheap as index funds. But, depending on the market environment, they give you a better option than just going long equities.

The big picture: With stocks near peak historical valuations, equity risk premiums near all-time lows, the threat of a slowing economy and restrictive Fed policy, I like the idea of reducing stock beta in my portfolio by owning these hedged vehicles.