With the recent downside market action and resulting spike up in VIX, I, like many market participants, am eager to see if this will be a relatively short “V” pattern with new highs being quickly re-established. Here’s a 10-year chart of the S&P 500:
As you can see, since early 2003, there has not been any serious drawdown and down markets were quickly erased with new highs in a matter of months. The growth versus inflation story both in the US and globally seems to have many investors feeling not too worried but not entirely care free. It’s the incredible resilience of the global markets to a continuous assault of significant events that has me wondering what does it really take to shock this bull market? Mideast turmoil and its effect on the energy markets hasn’t done it. An all out war (albeit short) in Lebanon, in addition to conflict in Iraq and Afghanistan, seems almost like a non-issue now. The UK subway bombing is an example of an even more “focused” event that shocked the market but in such a meaningless way in terms of severity and length.
Closer to home in the US, despite a White House administration that seems destined to be the ultimate case study for grad school management programs (G.W. Bush was the first US president to have earned an MBA, right?) with a chain of foul ups too long to mention, the markets have shown a nearly straight line upwards. However, G.W. Bush assumed office in early 2001 when the S&P 500 was at around 1350. Just a simple observation, but if you include distributions (as opposed to just a price based calculation using the above chart), the US market has provided close to cash equivalent returns over the Bush presidency.
Somehow I think if Gore won the election back in 2000, there wouldn’t have been too significant a difference in market performance although that’s certainly highly debatable. Well, I think there’d certainly be less laughs on the late night shows … I doubt Lieberman (or Edwards if Kerry won in 2004) would have done anything like shot someone in the face, but the Democrats are also damn good at screwing themselves with ease. The market was already on its way down and no matter who won the election back in 2000 nothing would have stopped the bear market. September 11th brought a quicker drop but spiked back up only to continue the downward trend until we hit bottom somewhere in the later half of 2002.
But now we’re at a completely different time. We’re near (S&P 500) or past (Dow 30) previous highs. And what interests me now is what remains highly resilient during the moments - even if they’re relatively short - when the market seems to release some steam. Hopefully, this kind of analysis not only finds good defensive performers in mini-corrections but in serious market declines as well. First, let’s take a shorter term look at the S&P 500:
We can see last summer’s market decline as well as the turmoil over the past month. In between is one of the smoothest bull markets I’ve seen. I think it’s too short to be considered a cyclical bull but at seven months, it was a fairly nice long run of about as straight a line as a market could have, and with a rate of ascent that makes it that much more incredible.
However, you plot some sectors over this chart and you see that there are areas that are even more incredible over the past year. With all the press related to commodities, one might guess that the oil & gas sector would have been a good place to put assets over the past year but all it’s brought is its usual high level of volatility:
At least it looks relatively uncorrelated to the S&P 500 so for asset allocators with an eye for diversification (not for Canadians, Russians and other oil producers of course) there looks like an argument to hold a certain portion of one’s portfolio here. What about gold & silver?
Pretty much the same story. Low correlation. With bigger drawdowns than in the oil & gas sector over this period, again the idea is to add some of this but not too much. It’s somewhat uncorrelated so it can dial down a portfolio’s overall volatility, but add too much commodities and watch your volatility skyrocket!
Obviously, something less gut wrenching is utilities:
No surprise, utilities are one of the classic defensive sectors. Compared to the broader market, it often time has a lot less volatility and, in fact, over the recent year’s chart looks like a really well run hedge fund. I’m not joking. Look at the behavior of the Dow Jones Utilities Average over the months of May/June 2006 as well as over the past 5 weeks in the chart above. During these times of market stress, the DJUA was relatively flat or slightly upwards (last summer) or strongly up (recent weeks). Otherwise, during other times it looks kind of like the index but on a month-to-month basis you don’t see a high degree of correlation. Unfortunately, the comparison of DJUA with hedge funds only goes so far as you can see in this 10-year chart:
Unlike nearly all hedge fund indices (as bad as they are as benchmarks I use them as the only decent source for comparison), you can see that the DJUA did not protect investors from the bear market of 2000-2002 in any way better than the broader market S&P 500 Index.
Still, my point is that utilities is one of a few areas where it clearly has been going strong even in comparison to the S&P 500 during this bull market. And, of course, as a defensive play it seems to do relatively well even in times of distress. Recent commentary has suggested that the new infrastructure ETF from SSGA, the SPDR FTSE/Macquarie Global Infrastructure 100 ETF (GII) is actually a global utilities fund in disguise. For review, refer to my previous posts covering infrastructure here and here. Some of my comments from those posts seem to suggest that infrastructure, like many areas that have shown new product offerings in the ETF space, have shown too great a rise and that investors might be wise to show restraint and wait for better valuations and a lower point of entry. Price action over the past few months have proven me wrong overall as shown in the following chart which includes several infrastructure oriented ETFs and CEFs:
All of these funds involve Macquarie and although they have different mandates you can see that they generally move in tandem. For example, although the S&P 500 had a modest increase in the month of March, all infrastructure funds in the chart above had a strong month except for the first week. Perhaps I was correct earlier this year when I addressed concerns of the recent strength in infrastructure oriented funds. The sharp declines in late February in line with the overall market seem to agree with this. However, their incredible concerted rebound was frankly unexpected. I would have thought that any rise would be in line with the broad markets, not the sort of out performance shown in the chart above.
Therefore, and perhaps not surprisingly, infrastructure and utilities are quite similar in that they have demonstrated an ability to deliver favorable performance in the good times, but more importantly, when the broad markets are not as strong. And the immediate corollary to this for me is the attention given to fundamental indexation whether through PowerShares or WisdomTree. Like other alternative weighted index methodologies, the focus is on value over growth. No one would argue that utilities are a value play, but so too is infrastructure with the stable income generated from its business operations (airport, highway, port, water service, etc.).
Lastly, I have seen some very brief commentary on the transports. Here’s a 3-year chart comparing the Dow Jones Transportation Average to the S&P 500:
Over 1 year, the S&P beats the DJTA. Over 2, 3, 4 or 5 years, the DJTA wins. Regardless of commentary relating to transports as a leading indicator, I can’t see this an anything more than a high beta version of the broader market. And in today’s environment, for the defensive oriented investor, this or an ETF in this space is likely one to avoid. Look how it behaved last summer, over the past month and in other times of market declines. But perhaps technology or in the chart below, internet stocks, are an even better example of a purely cyclical play … the perfect opposite of the defensive sector play:
This example goes too far to the other extreme but it clearly makes the point to differentiate how far apart a defensive sector like utilities looks compared to a cyclical sector and versus the broader market. Some may think of transports as a possible defensive play but in times of market distress, if you felt nervous about the S&P, transports would make you manic! Speaking of transports, I’d like to write about freight derivatives at some point. I continually neglect the derivatives market as there’s just so much happening in the ETF space but it’s just so interesting to see the continued innovation in the derivatives markets (property derivatives, housing derivatives, economic derivatives, weather derivatives). Some more for the “to do” list.
Bottom line: For investors concerned about providing an adequate level of defense for their portfolios, some sector tilts may provide greater diversification benefits than geographically based asset allocation. Rather than allocating more towards EAFE, or even emerging markets, investors may look to areas like utilities, infrastructure and other sectors that may have a better chance of sustaining past earnings levels or at least have minimal downside effects to general operations when the overall global economy softens. With concerns of greater correlations among asset classes and asset strategies, sector “bets” (yeah, it’s an active decision that may be right or wrong) are one of the more tried and true methods available to any level of investor.
Clearly, some sectors are better than others for defensive maneuvering. If sector rotation is to be fully explored as a viable strategy, thank goodness for the recent delivery of sector oriented ETFs brought to the market by ETF manufacturers, and especially the relatively younger providers who have brought some very interesting niche funds to the marketplace.