Growth investors have benefitted from the resiliency of stocks for quite some time now. The SPDR S&P 500 ETF (SPY) has traded above its 200-day moving average for 16 straight months and nearly every modest dip is bought with gusto. However, many investors are starting to notice swirling currents beneath the surface that threaten to change the path to profits moving forward.
In 2013 the hot tickets were small cap stocks, biotechnology companies, and solar names which all produced market-beating returns. However, the market leadership has changed dramatically in just the first three months of 2014. We are starting to see a confirmed shift to defensive areas of the market that has altered sector momentum and may perhaps even lead to more volatility.
Fortunately, there are a number of key strategies you can employ that will allow you to get out ahead of this near-term volatility and thrive as a result.
1. Value beating growth
Last year investors all focused on growth stocks that were posting fantastic gains despite valuations becoming stretched. However, the shift in strength this year has led to considerable outperformance in value stocks. The chart below shows how the iShares S&P 500 Value ETF (IVE) has begun to pick up momentum versus its counterpart in the iShares S&P 500 Growth ETF (IVW).
This move is characteristic of a shift to stalwart dividend paying companies such as utilities, telecommunications, and even large-cap technology firms with cash-rich balance sheets. My favorite ETF to play this value opportunity is through the First Trust NASDAQ Technology Dividend ETF (TDIV). This ETF is chocked full of technology and telecommunication stocks with large cash positions, mature business models, and established dividend histories.
TDIV just recently made new highs this year and is continuing to show signs that the upward trajectory is firmly in place. If institutional investors continue to reposition their portfolios to take advantage of value stocks this year, I expect this ETF will benefit from that shift.
2. Consider alternative asset classes for diversification
Another sector that has been the beneficiary of repositioning this year is REITs. The Vanguard REIT ETF (VNQ) is in the top five ETFs for new asset inflows in 2014 with nearly $2 billion. VNQ has gained over 11% to start the year and pays a 30-day SEC yield of 3.63%. This sector has been buoyed by lower interest rates, has continued to show strong relative momentum, and has been largely unaffected by broader equity volatility this year.
I consider REITs to be an alternative asset class because their returns are often times non-correlated with traditional stock market indices. They may offer an opportunity for additional growth and income this year in the context of a diversified portfolio. One of the advantages of VNQ over other ETFs in this sector is that it charges a miserly expense ratio of just 0.10%. That should please even the most fee-sensitive investor who is looking to gain exposure to a basket of publicly traded real estate companies.
3. Go International For Small Cap Exposure
Europe has continued to attract additional ETF assets and one of my favorite opportunities overseas is the WisdomTree Europe Small Cap Dividend Fund (DFE). This ETF gives you exposure to 250 smaller companies in foreign developed markets that are weighted according to their cash dividend payouts. This fundamental index approach has enabled DFE to capture over $1.5 billion in total assets and so far this year the fund has gained more than 8%.
European markets have not experienced the same shifting tides that the U.S. has this year and I think that DFE still has additional room to run on the upside if economic conditions remain favorable. Overseas diversification can be an excellent way to gain tactical exposure to opportunities that you may have otherwise overlooked.
4. Use volatility to your advantage
Some people are intimidated by volatility in stocks and fear a correction will wipe out their gains. However, I would challenge you to look at volatility as an opportunity to reposition your portfolio for success.
Use it to your advantage by taking inventory of your positions, cost basis, and risk tolerance. Once you have identified areas of strength and weakness, you can make strategic or incremental shifts to align your portfolio with the current market themes. That may include pairing back on high beta stocks or funds and shifting to more defensive sectors.
Freeing up cash and having some dry powder on hand can be an excellent way to take advantage of new opportunities if stock prices ultimately go lower.
5. Define your risk
One of my core tenets of portfolio management is that risk must be defined. To do that I always place a sell discipline on every position that I enter so I know where to exit if my thesis does not pan out. Everyone is going to make mistakes or enter an ill-timed trade at some point in their lifetime. The one thing you don’t want to do is let a bad trade turn into a bad investment that languishes in your portfolio and weighs on your returns.
One of the benefits of using an ETF over a mutual fund is that you can place a trailing stop loss on the position that moves higher as the price increases over time. That way you have a floor in place in case the tide turns against you and are prepared for any unforeseen volatility.
As always, the market is continuing to offer up changing dynamics and subtle clues that can be interpreted a number of ways. The one thing I would stress this year is to not get too bullish or bearish as conditions change. There will be a number of opportunities to adapt and prosper if you have a flexible mindset that takes into account both sides of the trade.
If you are an income investor or searching for additional dividend themes, you may benefit from this recent strategy missive as well.