The plan: be prudent, early.

Mar 01, 2019 | Alexander Mainella


Investors often forget that volatility goes both ways. This is not necessarily a bad thing because volatility creates opportunity.

The plan

  • Equities have room to run – that doesn’t change the fact that we are approaching the end of the economic cycle.
  • Investors need a plan to navigate this environment. Ours is simple: systemically shift our holdings towards quality, income and defensive growth.

Volatility goes both ways

Investors often forget that volatility goes both ways. Where the fourth quarter of 2018 was an example of what volatility is like on the way down, the first two months of 2019 have shown what it looks like on the way up. Of course, big movements to the upside feel a whole lot better for investors. But we caution against interpreting the current run-up as a sign that it’s smooth sailing from here. January and February should serve as a signal that choppy markets are here to stay. 

This is not necessarily a bad thing, because volatility creates opportunity. On one hand, downtrends can lead to attractive prices in high-quality companies that, for whatever reason, are not part of the current investing vogue. We took advantage of this at the end of last year by adding to quality names we believed were oversold, namely banks and energy companies. On the other hand, uptrends can provide favourable times to cut exposures that are no longer part of the long-term plan. To this point, the recent uptrend allowed us to shed some of our more growth-oriented holdings, particularly those inexpensive tech companies.

Despite these opportunities, the reality is that volatile markets can be unpleasant for investors and cause them to make rash decisions. It’s for exactly this reason that we’ve crafted a plan based on quality, income and defensive growth. We outline this plan further below. 

Economic Indicator Scorecard

Equities have room to run

Our plan is a function of the current economic environment, particularly that of the U.S. As we’ve highlighted in prior monthlies, our research tells us the health of the U.S. economy is the most important determinant of stock market returns. As the figure on the previous page shows, the indicators we track point to continued expansion over the coming year. This means global equities have more room to run, which is unambiguously positive news for investors.

The above does not change the fact that we are in the late stages of the economic cycle. Granted, the Federal Reserve has taken a pause for now, largely due to uncertainty surrounding the outcome of U.S.- China trade negotiations and waning business confidence. But underlying economic trends will eventually force interest rates up. The chief of these trends is the tightness of the labour market; job numbers are consistently healthy, companies are having difficulty filling positions and wage compensation is edging higher. This will eventually translate into broad-based inflation, force the Fed’s hand to continue raising rates and, ultimately, instigate the end of the current cycle and the onset of the next U.S. recession. But this process takes time. Trying to guess exactly how much time is a fool’s errand. For this reason, we’ve built a strategy that shifts our market exposure while still giving us the opportunity to capture long-term market returns. 

The plan: be prudent, early

The plan is simple: systemically shift our holdings towards quality, income and defensive growth. This process began last September and will continue to take place over the next several quarterly rebalances – hence the term ‘‘systematic.’’ After this time, we will be underweight growth equities and overweight defensive stocks and bonds that provide enhanced income through quality cash flows. This should minimize portfolio volatility while lowering our reliance on growth as a source of returns. In turn, this will alleviate some of the stress that invariably comes at the end of the market cycle and put our clients in a favourable position to shift back into growth when the cycle restarts. 

Why not make this shift now, all at once? As we outlined in the section above, the signs of an impending U.S. recession are not yet present.

Shifting to a defensive stance too aggressively now risks foregoing the historically substantial returns that presage the late phase of the market cycle. Granted, we will likely end up being early in our shift to prudence, which will give up a portion of these returns. Our strategy reduces this risk by spacing out it's timing; it acknowledges that we do not know when the end of the cycle will occur while still placing us ahead of the curve in making the shift. 

Over the longer term, we believe enhanced downside protection will provide a superior benefit to our clients. It also meshes with our core tenant of placing capital preservation ahead of taking outsized risks. As always, our ultimate goal is to empower our clients to lead fulfilling lives by helping them achieve their financial goals. This strategy helps them do that.

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