A time to play defense

U.S. yield curve inverts

Income investors (especially those near or at retirement) should always take a conservative approach when it comes to portfolio building. This is the time of life when cash flow and asset preservation are the top priorities. Capital gains are nice, but they should not take precedence. Especially now. As we have witnessed in the past few months, stock markets have become highly volatile. At the end of last year, we saw swings of more than 500 points a day in the Dow Jones Industrial Average. On Dec. 26 the Average posted a record one-day jump of 1,086 points after hitting a low for the year on Christmas Eve. Now that’s volatility! As an income investor, that’s not a game you want to play.

Unfortunately, we can probably expect a lot more of the same this year. Investors are trying to make sense out of a wide range of unknowns, any of which has the potential to send the markets into a tailspin. Here are just a few.

Earnings season. First-quarter financial results will start coming out next month, with several big banks among the first to report. Analysts are watching the numbers closely to see if the strong rally from December’s low is warranted in terms of earnings expectations. Especially after a number of companies issued warnings late in year that revenues and/or profits would be lower than expected.

Trade wars. The U.S. and China are talking. Good. Will they reach a deal? Who knows? The current tariff truce, which was set to expire this month, seems to be holding, unless President Trump changes his mind (which he has been known to do). If the negotiations break down, or go into an indefinite overtime, world trade will be hurt with a resulting impact on global GDP growth. Investors will not like that.

Interest rates. Federal Reserve chair Jerome Powell has indicated that the pace of rate increases may slow in 2019. That would be good news for stocks – rising rates always depress share prices.

Defensive strategy

These issues are going to take time to play out, and we will undoubtedly see other concerns emerge as the year progresses. The U.S. yield curve actually inverted last week (that’s when yields on short-term government issues exceed those on long-term bonds). In the past this has often been a reliable indicator that the economy is on the verge of a slowdown or recession, along with a bear market in stocks. Will it happen this time? Who knows? Your best option in these circumstances is to go on the defensive, if you are not already there. Here is what I suggest.

Review your asset mix. Many people probably have too much equity exposure. The long bull market increased stock valuations significantly, even those of low-risk companies. For example, in January 2009, shares of power utility Fortis Inc. (TSX: FTS) were trading in the $24 range on the TSX. Today they are almost double that. So even if you didn’t invest another penny, Fortis accounts for a larger portion of your assets. Multiply that by all your other stocks and you can quickly see how valuation creep can throw your asset allocation off-kilter.

If you haven’t done so recently, set aside some time to review all your holdings and calculate what your current asset allocation looks like. If more than 60% is in equities, consider reducing that position, keeping tax consequences in mind, of course.

Ideally, income investors should have no more than 50% of their portfolio exposed to the stock market at this stage (less if you are over 65). I suggest holding 10% in cash (15%-20% if you are over 65) and the rest in bonds or bond funds. The Canadian bond market (as measured by the FTSE Canada Universe Bond Index actually finished 2018 modestly in the black (as opposed to an 11%+ loss on the TSX) and is in positive territory so far in 2019 (+3.5% as of the close on March 22).

Buy utilities. I wrote at the end of last year in my newsletters that I thought utilities were oversold and offered good value and attractive yields at that time. Fortis hit a low of $43.58 on Dec. 24, shortly after that column was published, and has since recovered to $49.30 (March 22). Emera Inc. (TSX: EMA) closed at $41.88 the same day and now trades at $49.40. Algonquin Power and Utilities (TSX: AQN) bottomed at $13.36 that day. It has recovered to $14.95 since then. We’re only looking at a short time frame here, but I believe my assessment that utilities are a good buy at these levels will prove valid as the year unfolds.

Buy REITs. REITs surprised in 2018 by finishing in the black, despite rising interest rates. They have continued to edge higher so far this year, with the S&P/TSX Capped REIT Index up 13.4% in 2019 (to March 22).

Add bonds as insurance. In a recent analysis of the economy and the markets, GLC Asset Management, which looks after more than $50 billion in investors’ money, said: “Fixed income’s value as a risk mitigation tool has increased and continues to increase the longer we go in the cycle.” The returns on fixed income won’t be great, but think of your bonds as insurance against a market meltdown.

Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder and The Income Investor newsletters, which are available through the Building Wealth website.

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Notes and Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting, or tax advice. Always seek advice from your own financial advisor before making investment decisions.

Photo: Valery Egorov