Six Rules For Navigating Volatile Markets
The gyrations of U.S. equity markets on Wednesday -- the Dow Jones Industrial Average initially surged almost 200 points, turned negative, then finished the day up 122.10 points -- were yet another demonstration of generalized increased volatility.
These days, swings in the Dow of several hundred points seem to be the rule rather than the exception, and occur whether the news of the day is big, small or nonexistent. And these wide U.S. fluctuations affect and are affected by global markets that are at least as tentative and jittery.
As I have argued, this bout of market volatility will be with us for a while, especially as it is part of a bigger set of economic, financial, policy and technical transitions. In addition to larger up and down movements in both individual securities and market indices, it will result in occasional price overshoots, contagion within and across market segments, unusual asset class correlations and some sharp rebounds.
There are six major implications for investors:
- Be on the lookout for good names trading at really cheap levels: Sudden market air pockets, such as the one a few weeks ago (and there will be lots more), can drag down even the best securities, offering investors interesting opportunities. This is particularly the case for shares at the two ends of the market liquidity spectrum: securities with limited liquidity, which experience disproportionate moves because just a few small transactions can easily reprice the whole complex; and securities that are so widely held that they end up serving as ATMs for investors lacking liquidity from other assets.
- Use the periodic bouts of sharp market rebounds to trade up in quality: These sudden market retracements, such as the one taking place now, provide an opportunity for investors to upgrade their portfolio. In trading up into such securities, investors should be particularly mindful of the attributes that enable companies and sovereigns to successfully navigate the new (higher) volatility paradigm. These traits include robust balance sheets, low debt, good management and an operating edge that is hard for competitors to imitate.
- Use measured investing techniques (such as dollar cost-averaging) when taking on added exposure to fundamentally disrupted market segments that are subject to high mark-to-market risks: The change in the volatility paradigm adds to the travails of asset classes that already have been destabilized by fundamental demand and supply shocks -- such as oil and emerging markets. The resulting carnage offers selective opportunities that are likely to prove very remunerative over the longer-term. But the scaling of such investments must be done in a way that enables the holdings to be maintained through harrowing mark-to-market moves.
- For now, think of cash as part of the strategic (and not just tactical) allocation in a diversified portfolio: With asset class correlations becoming less predictable and dependable, the traditional (bond-equity-commodity) portfolio diversification no longer offers investors the same measure of risk mitigation. This is accentuated by high starting valuations for both bonds and equities. As a result, investors would be well advised to hold a higher-than-normal cash balance -- not only to give them the tactical opportunity to pick up bargains, but also for strategic risk management.
- Continue to look for opportunities that have not been directly affected by central bank liquidity injections: These are hard to find, but can be especially remunerative. Startups and certain maturing segments in new tech appear particularly attractive, as do transformational tech-driven sectors in the more robust emerging economies.
- Remember that obvious divergences in country fundamentals don't always translate to commensurate financial market out-performance: Although the economic outlook for the U.S. remains brighter than for most other countries, the financial market out-performance may not be as strong in general terms. Valuations have moved quite a bit. Traditional indices for both equity and corporate bond exposures are far from fully insulated from developments in the rest of the world. One important qualification: U.S. companies still tend to have quite a bit of cash on their balance sheets. That should be a significant differentiating factor for those wishing to go long U.S. corporate risk (bonds and equities) as compared to similar assets in the rest of the world.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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