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Staying Defensive in a Difficult Market
November 20, 2008
Investors have become increasingly worried that the downturn in the global economy might be deeper and longer than expected. Now that the United States, Europe, and Japan have all officially entered a recession and emerging-market growth has been stalled by frozen lending, there appear to be few opportunities for investors to find growth.
Stay defensive with stock portfolios
Uncertainty about the economy drove the Dow Jones Industrial average down to below 8,000 on Wednesday as the S&P 500 hit a five-year low. Market volatility remains at historically high levels, with the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) closing at 74.26 on Wednesday, down from its all-time high of 89.53 in October but still at an extremely high level. (In normal times, the VIX ranges from 15 to 20.) Hedge funds and mutual funds continue to have significant redemptions, forcing them to sell stocks into already depressed markets. Corporate earnings expectations continue to come down, driving the markets even lower. We believe that the markets won’t be able to move forward until stock prices are able to remain stable – even in the face of bad news. Given current market conditions, we’re looking for an opportunity to trim our current equity exposure on market strength.
Investors would be wise to remain defensive with their stock portfolios by investing in stocks that are good hiding places from which to weather a downturn – like consumer-staple and health-care stocks. Consumer staples and health care have been the best-performing sectors of the S&P 500 year-to-date, losing 18% and 26%, respectively. Earnings estimates for these companies also tend to be more reliable than those for more cyclical sectors.
The flight to quality continues in fixed income
The credit markets remain in turmoil as investors continue their flight to quality. Yields on a wide variety of short-term and long-term bonds have shot up recently as prices have fallen. Although banks have become more willing to lend to each other at lower rates (reflected by the current LIBOR* rate of 2.17% and TED spread** of 2.11%), credit still remains tight. Investors continue to seek quality, as evidenced by the recent high demand for U.S. government bonds.
*The London Interbank Offered Rate (LIBOR) is an average of interest rates offered in the London interbank market for 3-month dollar-denominated loans.
**TED spread is the gap between the three-month LIBOR rate and the three-month Treasury bill rate.
Economic news continues to be gloomy
Recent economic data indicate significant weakness in the U.S. economy and the possible threat of a deflationary environment. On Wednesday, consumer prices as measured by the Consumer Price Index plunged by 1%, the largest drop since records began in 1947. The drop reflects a significant decline in gas prices, with U.S. crude oil for December delivery falling 77 cents to $53.62 on Wednesday. Housing starts fell to a record low in October, a fall of 4.5%, driving new construction to its lowest level since just after World War II. On Tuesday, the government released its producer price index, with wholesale prices in falling 2.8% in October, a record drop. The Federal Reserve sharply lowered its projections for economic activity this year and next and signaled that additional interest-rate cuts may be needed to help combat the worst U.S. financial crisis in more than a half-century. Fed Funds futures are pointing to a 0.50% interest-rate cut at the next Federal Market Open Committee meeting on December 18.
Definitions
S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks.
Chicago Board Options Exchange (CBOE) Volatility Index (VIX) shows the market’s expectation of 30-day volatility and is used as a measure of market risk. It is constructed using the implied volatilities of a wide range of S&P 500 index options.
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This information represents the opinion of FAF Advisors, Inc., and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. The factual information has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Past performance does not guarantee future results.
FAF Advisors, Inc., is a registered investment advisor and subsidiary of U.S. Bank National Association.
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