Opportunities in a down market

2015 is shaping up to be a pretty poor year for investors. For the last one year period, all major asset classes are flat or negative. Below is a one year chart from capitalspectator.com showing us a pretty broad sample of various asset classes.

One year return chart

Interesting to note as well are some of the extreme differences of returns for US stocks. For example, although the Dow Jones Industrial Average is flat for the year, 8 of the 30 Dow components are down 20% or more from their recent highs. We’ve read in various places that only ten or so stocks in the S&P 500 are positive in 2015, meaning the other 490 are negative, some severely so. For example, Warren Buffet’s Berkshire Hathaway is down nearly 15% for the year. Macy’s is down over 40%. This large divergence of returns has historically been a negative for the markets. Typically, in a healthy bull market, most stocks do well. Hopefully, the broad market is simply in a period of resting and 2016 will be a better year. Time will tell.

Although markets that go down are not fun, situations like these do create opportunities for patient investors. Here are a few ideas we consider relatively attractive for investors.

Income Oriented Closed End Bond funds. Closed end funds (CEFs) are similar to open end mutual funds but have a few differences that may make them attractive at times (but also entail associated risks). Closed end funds are structured so that they can trade at a premium or discount to their net asset values (NAV). This differs from conventional open end funds which always trade at their NAVs. Currently, the average discount for the universe of available CEFs trades at very high levels. A basket of income oriented CEFs can easily be purchased at discounts to their respective NAVs of 10% or more. Most funds are also paying nice distributions, in the area of 8% or greater. What’s more, many of these funds are well off their highs due to the poor performing year in the markets. The bottom line is an investor can now purchase reasonably priced assets with nice yields at 85 to 90 cents on the dollar.

It’s important to understand that there are more risks involved when investing in closed end funds compared to conventional open end funds. To learn more, please go here.

Cheap, High Quality Stocks. Consistently owning inexpensive or cheap, high quality stocks has substantially outperformed owning expensive, low quality (junk) stocks over time. This makes intuitive sense. Buying a high quality asset at a low price builds in a margin of safety if things go wrong. Rolling the dice on high flyers almost always ends poorly. Many great investors (e.g.Warren Buffett) have built fortunes on buying quality assets on the cheap.

Fortunately for astute investors, buying cheap and high quality stocks can at times fall substantially out of favor and present an opportunity. We are experiencing one such opportunity today. The chart below from alphaarchitect.com shows us that cheap, high quality stocks have vastly underperformed expensive, low quality stocks. The performance difference is an astonishing 30% for the year!

quality junk spread

Cheap, high quality stocks are attractive here, especially relative to the broad market (e.g. SP 500).

Emerging Markets. Many stock markets outside the US look reasonably priced at today’s levels. Below is a chart showing the relative valuation of the US versus the rest of the world (ROW). US stocks have not been this expensive relative to the ROW since the tech bubble.

US Stocks vs Rest of World

Emerging markets have not performed well in the last few years. Like any cheap asset class, things could get cheaper in the short term. That said, we believe the asset class is very much a viable place to look for long term growth.  Smarter people than us discuss the asset class in more detail here and here.  Currently, emerging market stocks are priced to earn reasonable absolute returns and certainly better relative returns than what’s available in the developed world markets. In fact, we feel there is a high probability that emerging markets will be the best performing asset class over the next ten years.

In conclusion, we feel that these three opportunities may be worth owing in a balanced portfolio. They are priced to earn reasonable returns relative to their risk, neighboring in the high single digits to low double digits over the next couple years.

 

About Michael McGinley, CFP®, AIF®

Michael McGinley has worked in the financial services industry for over 15 years. He is currently a partner at Providus Advisors, an investment advisory firm located in Chandler, AZ.

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