Insulating a Portfolio from Volatility
Hiding in Fixed Income as Key Support Levels in Equities Being Tested
Alfred Lee, CFA, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management
alfred.lee[at]bmo.com
October 6, 2011
Recent Developments:
- Unlike traditional business cycles, driven largely by economic growth and decline, the last two cycles were driven by a great deal of monetary stimulus vis-Ć -vis low interest rates. When money is inexpensive to borrow, the use of leverage is unintentionally encouraged. As we have discussed a number of times in the past, one metric we watch very closely is the NYSE Margin Debt Index ("Index"). In our view, the Index gives us a close proxy of the amount of leverage in financial system.
- We track the Index relative to its 12-month moving average (MA). When the indicator is above the 12-Month MA, the use of leverage is expanding. However, when the Index moves below its 12-Month MA, this is an indication that margin use is deleveraging. As leverage in the system is significant right now, there is downside potential should investor sentiment sour and deleveraging set-in.
- Another measure we have often discussed in the past is intra-market correlation. The CBOE S&P 500 Implied Correlation Index measures the correlation between individual securities in the S&P 500 Composite implied through option prices. This measure has recently moved to a high of 90.3, suggesting diversification across stocks will likely not provide downside protection.
Potential Investment Opportunity:
- On August 15th, we issued a report titled "Navigating Market Volatility," where we recommended investors pare back their equity exposure in favour of fixed income. We continue to favour fixed income until we see volatility dissipating. Over the last several months unfortunately, politics rather than macroeconomics or fundamentals have dictated stock prices. As a result, market clarity becomes less visible, leading to further volatility.
- While we are currently recommending an overweighting to fixed income, a sudden policy move could cause an extended risk rally. Should this happen, an overweight in fixed income would underperform. However, should it be an extended rally, investors would miss the initial onset and look for momentum to return before repositioning to equities. Should the relief rally be short in nature, then equities were not the appropriate asset class in the first place. The policy move required would need to be significant, such as a third quantitative easing (QE3) or a European TARP like plan. Federal Reserve (Fed) Chairman Ben Bernankeā¬ā¢s recent comment that the Fed is prepared to take further steps should the economy falter may be a hint of further stimulus down the road. With major North American equity indices recently testing key support levels, we wouldnā¬ā¢t be surprised to see a relief rally. However, without the ā¬Åāpanaceaā¬Ā that the market seems to be looking for, that said rally will likely be short-lived and controlling portfolio volatility should be an investorā¬ā¢s first concern.
- Coming into 2011, we recommended investors overweight short-duration fixed income as we believed higher interest rates were imminent. As the summer progressed and the economic picture worsened, the Bank of Canada is now taking a more dovish stance on monetary policy. As a result, we have been recommending the mid-part of the yield curve as we believe rate hikes are likely postponed until at least Q2 2012. By taking some duration risk, investors can add additional yield to their investment strategy. We believe Canadian mid-term corporate bonds and mid-term federal bonds will help investors mitigate some portfolio volatility. Investors looking to execute this trade idea through exchange-traded funds (ETFs) may want to consider the BMO Mid-Corporate Bond Index ETF (ZCM) and the BMO Mid-Federal Bonds Index ETF.
Chart A: Margin Debt Contraction Has Preceded Prior Two Sell-Offs
Source: BMO Asset Management Inc., Bloomberg
Chart B: Equity Market Correlation Continues to Rise with Volatility
Source: BMO Asset Management Inc., Bloomberg,
Chart C: Mid-Term Bonds Can Help Drive Down Portfolio Volatility
Source: Bloomberg, BMO Asset Management Inc.
*All prices as of market close October 5, 2011 unless otherwise indicated.
Disclaimer:
Information, opinions and statistical data contained in this report were obtained or derived from sources deemed to be reliable, but BMO Asset Management Inc. does not represent that any such information, opinion or statistical data is accurate or complete and they should not be relied upon as such. Particular investments and/or trading strategies should be evaluated relative to each individual's circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment.
BMO ETFs are managed and administered by BMO Asset Management Inc, a portfolio manager and separate legal entity from the Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange-traded funds. Please read the prospectus before investing. The funds are not guaranteed, their value changes frequently and past performance may not be repeated.
