Defensive Positioning into 2020: Solving Your U.S. Large Cap Equity Problem

You may not have realized it, but you have a large cap problem. The current bull market that started in March 2009 is now the longest bull market in modern stock market history. By many metrics the market could be considered overvalued, which presents investors and their advisors with a dilemma: how do you continue allocating to U.S. equities in a prudent way?

Forward-Looking Focus on Valuation

At this point of the market cycle, it may be hard for some investors to justify putting new money to work in companies whose valuations have been stretched to elevated levels. A more selective approach that seeks to allocate to companies trading at a lower relative valuation may provide more of a cushion in the event that markets take a tumble while also offering the potential for greater upside if equity markets continue to rise.

Traditionally, most valuation strategies are backward looking, in that they incorporate historical fundamental metrics such as earnings and book values to determine current valuations. We believe valuations should also include an assessment of a company’s business and its prospects for future profit generation.

Source: Morningstar Direct as of October 31, 2019. Past performance is no guarantee of future results.

Morningstar Wide Moat Focus Index is designed to include companies with Wide Economic Moats, or companies Morningstar deems to have competitive advantages that are sustainable for at least the next 20 years. The Morningstar Wide Moat Focus Index incorporates a forward-looking price-to-fair value metric to select at least 40 stocks trading at the lowest relative price, and rebalances quarterly. By including a forward-looking valuation metric into its investment thesis, investors may be able to better protect themselves from high-flying valuations, potentially boosting returns and allowing for a more favorable risk/return profile.

Tactical Strategies May Offer Protection from Sustained Bear Markets

One of the oldest, most popular applications of a tactical strategy is trend following. Trend followers aim to be invested during the good times, when the market is going up, and to sit it out during the bad times, when the market is falling. Moving averages (MA) are commonly known trend following indicators, where the MA is an average of prices over a predetermined time horizon, whether that’s 200-days or 50-days. Moving average strategies can help investors gauge whether the market is trending upwards or downwards, and simple moving average strategies can help to protect investors from sustaining major losses during a long bear market.

Market breadth is another form of trend following that we explored in a recent whitepaper. It provides investors with additional information, by measuring the price trends of the underlying index components of the broad market in an attempt to more accurately differentiate between small and large market corrections. A market breadth strategy may provide investors with a more robust signal, because the strategy signals are incorporating more granular data (i.e., sector price trends) when compared with single top-line index returns.

Multi-Statistic

5/31/1991 to 8/31/2019

Source: VanEck as of 8/31/2019. Analysis compiled using monthly data for the S&P 500 Index from 5/31/1991 – 8/31/2019. Past performance is no guarantee of future results.

The table above shows an example of breadth strategy that measured the price trends on each of the 24 industry groups in the S&P 500. Trends were measured by a 150 day moving average and a 400 day moving average, and when 13 or more of the industries turned bearish, the portfolio was sold and U.S. Treasury bills were purchased. Such a market breadth strategy outperformed the S&P 500 Index on each of the metrics listed. It generated a higher return, lower volatility, higher risk-adjusted return and significant downside protection. It is possible to further refine the parameters employed based on the unique risk and return characteristics of each industry.

All of the Up, None of the Down….Doesn’t Exist

Unfortunately, there is no magic bullet that will solve late-cycle investment questions for investors. Predicting the future is impossible. A bear market is inevitable, and trying to time the market using human intuition is a fruitless project.

Instead of trying to call the top, or catch a falling knife, we believe that investors should thoughtfully consider a range of options to account for numerous outcomes. Those options could include incorporating more robust forward-looking valuation metrics that helps to protect against overvalued companies. Another option would be to incorporate a tactical strategy which could potentially protect investors during a sustained bear market scenario. Rather than trying to predicting a bear market, we believe investors should instead position themselves to be prepared for one.