Recognize The Risk Of A 2008 Repeat And Allocate Accordingly

by: Oscar Sahlberg

With stalling growth in the world, the potential blowup in the euro area and continued high indebtedness, especially in the public sector, the risks of a second dip are staring at the investors square in the face. What’s worse is that the markets are exhibiting patterns similar to those of pre-crisis 2008. For now, the credit markets are open and the balance sheets seem OK but we’ve seen how quickly the whole thing can unravel in case of a panic.

First, a detailed look at volatility is in order. We have recently seen some big up and down days (2 5%+ days in August and 3 -5% days). And while the direction of the markets is decidedly down, the strong daily positive reactions show that there’s yet to be total capitulation. What we saw in 2008 was a period of elevated volatility and a consequent capitulation that took the VIX to 80 and the markets all the way down to 666 in S&P500 and Russell below 350.

Second, yields and spreads give a cautionary tale as well. The 10 year yields are dipping below their 2008 lows of 2% while high yield spreads have moved over 7.5%.

Finally, the analyst community is also awakening to the risks by cutting estimates. While some argue that the valuations are attractive, valuation metrics have two dimensions, price and estimates. High estimates may create a false sense of security. What we saw in 2008 was a dramatic cut in estimates as reality started surfacing. While we are not at the same level of cuts vs increases, the trend of the revisions show a much higher number of cuts vs upgrades.

Therefore the investors will have to be very cognizant about the very real risk of a repeat of 2008. While there is no guarantee that history will repeat itself and the trajectory will be the same (so no overlaying of charts of 2008 to 2011 like Paul Tudor Jones in 1987), investors should remind themselves of the saying: history doesn’t repeat itself, but it does rhyme.

Given that we are out to discover the lessons that history can teach us, a similar exercise is likely to yield a potential portfolio allocation. What we saw in 2008, perhaps unsurprisingly, was the triumph of the relative trade. Consumer staples, healthcare and utilities were the clear winners, showing positive relative performance between 10-25% compared to the wider index. Energy, materials and financials were clear losers.

Therefore a good strategy going into a recession scenario would be to re-balance portfolios that would reflect overweight in those sectors that perform well relatively while staying underweight those that are likely to perform poorly.

Investors have several tools to achieve this. One would be outright purchase or sale of stocks. Second would be to adjust portfolio weights by going long or short sector ETFs to achieve the desired target allocation weights. Yet another method is to use options on these indices if you do not want to increase gross exposure by too much. One can buy calls on defensive sector indices and finance them by writing calls on those that are more prone to selloffs. Whatever the tool he/she uses, one thing that an investor cannot afford is to stay immobile while facing diversifiable risks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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