4 ETFs to buy to avoid the tremors

Vancouver-based HollisWealth® portfolio manager Elvis Picardo, thinks it would be safe to assume that market volatility will be higher this year than it has been in the last couple of years. Market action over the next few months will determine whether the ‘buy the dips’ mantra is finally turning into ‘sell the rallies’.

ETFs_to_BuyDo the volatility tremors portend a major market quake?

For us denizens of the West Coast, it seems inevitable that a major earthquake will occur in the region at some point in time. The difficult part is in trying to forecast when this will occur. Will it be a year from now, 10 years, or 50? Impossible to predict, but meanwhile, we live with the occasional tremors and temblors, hoping that the Big One isn’t around the corner.

The recent surge in market volatility feels similar, albeit on a smaller timescale. Was the huge spike in volatility in the first week of February a natural corollary to the unusual calm of 2017, or was it an early indication of a major market quake within the next couple of years?

At the time of writing, although stocks have recouped part of their losses from a week of gut-wrenching volatility, the market’s gyrations could indicate that the January barometer might not be as reliable this year as it usually is, in our opinion. The January barometer holds that the performance of the S&P 500 in January sets the tone for the rest of the year—a positive January means that the S&P 500 will have an up year, and a negative January implies a down year. This is especially true when the S&P 500 advances more than 5 per cent in January. According to Fidelity Investments, of the 13 times that the S&P 500 has gained more than 5 percent in January since 1945, it has advanced in the remaining 11 months of the year 85 percent of the time.

A fallible barometer

But the barometer is not infallible, especially when January is negative. One need look back no further than 2016, when the S&P 500 finished the year up 11 per cent despite being down 4 per cent in January. Will 2018 prove to be a year when the index is unable to build on its 5.6 per cent January gain, the 11th-best since 1945?

Certainly, the speed with which market sentiment unraveled after US equity indices reached record highs on January 26 was quite astonishing. At their February 9 lows, US indices had tumbled about 12 per cent from their peaks; this was the fastest the S&P 500 had plunged into a 10 per cent correction since 1950.

Prices plunge, yields rise

The market rout commenced on February 2, after a triple-whammy of ‘threes’. A robust US jobs report showed wages in January rose almost 3 per cent from a year ago, the fastest annual pace since 2009. Such strong wage growth spurred speculation that the Federal Reserve would need to boost its benchmark rate more than the three times this year that was factored in by investors. As a result, bond prices plunged and the yield on the 10-year Treasury rose to a four-year high of 2.85 per cent, inching closer to the 3 per cent threshold that bond guru Jeff Gundlach and others have identified as a level that would signal a bond bear market.* If bond prices plunge, spiking yields could imperil the second-longest equity bull market in history.

On February 5, the Dow Jones Industrial Average plunged intraday by 1,600 points, the biggest point drop in history. It closed the day down 1,175 points and endured another 1,000-point drop on February 7. Overall, the week ended February 9 was the worst one in two years for US equities, with the S&P 500 losing 5.2 per cent for the week.

Despite the significant decline and upsurge in volatility, most Wall Street strategists continue to advocate the ‘buy the dips’ investment strategy that has served so well since 2009. A Bloomberg article** notes that since the start of the current bull market in 2009, US and global equities have experienced nine distinct sell-offs and have bounced back every single time. In addition to the aforementioned January 2016 sell-off, other notable dips include the August 2015 plunge caused by China’s shock devaluation of the yuan; the correction of the summer of 2011 that was triggered by Standard & Poor’s lowering of the US government’s credit rating; and the 16 per cent slide in 2010, from April to July, a period that included the ‘Flash Crash’ on May 6.

Europe and Japan look good

Each of those episodes could have spelled an end to the bull market, but it recovered and lumbered on. However, it may not be as easy for the markets to post a sustained recovery this time, because the era of cheap money is coming to an end, at least in North America.

Since the Bank of Canada and the Federal Reserve are both poised to push up benchmark interest rates substantially this year, we recommend increasing equity exposure to regions where monetary policy is still accommodative. Two such regions are the Eurozone and Japan, the biggest of the advanced economies, excluding the United States. Europe is enjoying an economic resurgence as it grows at the strongest pace in a decade, underpinned by healthy domestic demand and rising corporate profits. Japan is finally emerging from its prolonged economic slump, with GDP growth estimated by the IMF at 1.8 percent in 2017, helped by stronger international trade and fiscal stimulus.

The BMO MSCI EAFE Hedged to CAD Index ETF (TSX—ZDM) or the unhedged version (TSX—ZEA) provide exposure to both these regions. Both these exchange traded funds track the MSCI EAFE index, which represents the performance of more than 900 stocks across 21 developed markets in Europe, Australasia and the Far East. These ETFs’ geographic diversification makes them worthy of consideration for Canadian investors whose investment portfolios tend to be concentrated in North America. The biggest stock weights in ZDM and ZEA are household names such as Nestlé, HSBC Holdings, Novartis, Toyota and Roche.

Our investment thesis for ZDM and ZEA is that since Eurozone and Japan are much further behind in the economic recovery cycle than North America, their stock markets may have more room to run. ZDM gained 6.5 per cent in 2016, 16.1 percent in 2017 and was up 1.6 per cent in January; corresponding figures for ZEA were -1.9 per cent, 17.1 per cent, and 2.1 per cent.

On the fixed income side, where the environment is growing increasingly more challenging, we like the First Asset Enhanced Short Duration Bond ETF (TSX—FSB). This exchange traded fund aims to provide positive absolute returns over any 12-month period with very low volatility and steady monthly distributions regardless of the interest rate or credit environment. FSB primarily focuses on US and Canadian corporate bonds. The average duration of the ETF’s holdings is 0.4 years, well below its maximum of two years. The ETF currently pays a monthly distribution of 2 cents, for an indicated yield of 2.4 percent. It is also available in a US dollar version (TSX—FSB.U).

Overall, it would be safe to assume that market volatility will continue to be markedly higher this year than it has been in the last couple of years. The tug-of-war between bulls and bears will likely be more pronounced this year, in our opinion, as positive factors such as accelerating global growth and strong corporate earnings are offset by rising bond yields and fears of a more hawkish Fed. Market action over the next few months will determine whether the ‘buy the dips’ mantra is finally turning into ‘sell the rallies’. Should that happen, it may be a sign that the Big One in the markets is closer than most investors currently assume.

* Bloomberg (February 1, 2018) – PIMCO views 3% yield as an opportunity where others see a bear signal.

** Bloomberg (February 8, 2018) – Far from unprecedented: Nine sell-offs like this, and nine rebounds.

This information has been prepared by Elvis Picardo, Portfolio Manager, HollisWealth®, and does not necessarily reflect the opinion of HollisWealth®. HollisWealth® is a division of Industrial Alliance Securities Inc., a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. The information contained in this publication comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. For more information about HollisWealth, please consult the official website at www.holliswealth.com.

Elvis Picardo, CFA, CIM, is a Portfolio Manager with HollisWealth® in Vancouver. Prior to joining HollisWealth, he was Vice-President Research and a Portfolio Manager at a leading independent investment dealer in Vancouver. His experience in international capital markets has enabled him to develop a global perspective on portfolio management.

This is an edited version of an article that was originally published for subscribers in the February 2018/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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