The Two Things Investors Must Do to Prepare for Uncertainty

This year has started with uncertainty, and yesterday’s data and the Fed minutes that were released did nothing to clarify the situation. In the morning, we got ISM Manufacturing numbers, that included a PMI, where a print under 50 indicates contraction in manufacturing activity, of 48.4. Then, the Fed released the minutes of last month’s meeting, in which they confusingly identified some signs of hope in the economy, while simultaneously said they expected rates to remain elevated for a long time.

Little wonder, then, that investors don’t know what to do. The Fed saw improvement in the economy, which hints at avoiding a full-blown recession, while purchasing managers were cutting back in a way that suggests that recession, or at least economic contraction, is already here. And if we can’t make sense of where we are at now, what hope do we have of predicting where we will be in a few months, let alone by the end of the year?

So, the best strategy for investors right now is probably to adjust their portfolio to reduce risk to some extent and then avoid the temptation to react to news or headlines. That, though, is easier said than done on both fronts.

The problem with not reacting to news is that you cannot just ignore the headlines. You need to know what is going on in the economy and burying your head in the sand just wouldn’t be smart. It is just that each data point and news report seem to tell a different story at the moment. One day the news is positive and the market soars, the next it is negative, and stocks drop. However, if you look at the net effect of all that, it is not that drastic.

For all the contradictory indicators, and through all the ups and downs, yesterday’s close in the S&P 500 was just a couple of percent away from where it opened September last year. That is not the kind of move over three months that should really prompt any major changes for long-term investors, even if some of the moves in between looked ominous or vey hopeful.

When it comes to setting up to resist some of the volatility, the key at times like this is not necessarily to just move to an ultra-conservative portfolio. Being overweight bonds won’t help if the Fed keeps raising rates, and “recession proof” areas of the market, like healthcare and defense, for example, represent little or no value at current levels. The problems have been foreseeable for a while, so stocks in those sectors, along with inflation beneficiaries such as materials and energy, have already posted significant gains.

Instead, it may be better to stick to your current allocation in terms of stocks and bonds but look for ways to diversify your stock holdings. Diversification can minimize the impact of downturns but still allow you to benefit on the way up, so is a good fit for uncertain times, but in order to do it effectively, you sometimes have to think outside the box, for want of a more original phrase.

As well as diversifying in terms of market cap and industry, for example, it may well pay this year to increase your geographic diversity. U.S. investors tend to focus on America for understandable reasons, but when the going gets tough, looking outside the country’s borders is often smart. There is one area that I like in these conditions on that basis that may surprise some: emerging markets.

I know, I know, buying emerging market stocks doesn’t seem all that smart if you are trying to reduce risk in your portfolio, but there are a couple of factors that indicate that EM ETFs could easily outperform domestic stocks this year. The likelihood of a resurgence in China as the move away from their “zero-covid” restrictions and a weaker dollar as the Fed slows the pace of rate hikes look like good bets in 2023, and both will benefit EM stocks considerably.

The point here is not that you should all rush out and establish a big position in EEM or VWO or anything, just that you should look to diversify in ways you might not have thought of before. What you are trying to do is own things that have diverse influences on their price, not just diverse characteristics.

If you do that, diversify in terms of price drivers, and ignore the day-to-day headlines, you won’t necessarily avoid losses on downturns, nor will you make fantastic gains on rallies. What you will do, though, is smooth out what look like being significant bumps over the next few months, or maybe even throughout the next year.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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