Many investors are becoming increasingly concerned that a recession may be on the horizon as North American markets continue to climb higher despite global trade concerns.
A recession is defined as a temporary economic decline during which trade and industrial activity is reduced. It is typically identified by a fall in Gross Domestic Product (GDP) over two successive quarters.
While analysts’ consensus suggests that the current economic environment supports continued, modest growth for the near future, it is important to plan ahead, be active and adjust accordingly.
Conservative investors would be most sensitive to a market contraction given that many have a shorter investment horizon and are less tolerant to risk and volatility. Several adjustments may be made within a portfolio to adapt to changing market conditions.
It is important to note that while options are an integral part in managing risk and enhancing returns during a market decline, options strategies should be an overlay to a solid portfolio, purposely built for the market at hand.
Portfolios are typically built with specific weightings toward certain asset classes and sectors based on what is believed to perform best under current market conditions.
Fixed Income
During a recession, the yield curve traditionally inverts causing a Fixed Income allocation to typically increase in value.
High Yield/Low Beta Stocks
High yield refers to companies paying an attractive dividend, while low Beta suggests that these companies historically are less volatile than the broader market and therefore would be expected to go down less.
A “high yield / low beta” sleeve may be concentrated in the Telecom, Utilities, Real Estate sectors that exhibit a certain degree of duration. The duration will typically cause these securities to increase in value during an inverted yield environment. In addition, adding companies that have low revenue sensitivity to GDP growth will help insulate the portfolio from some of the broader market risk.
Value Stocks
The effects of a market pullback should be diminished to a certain extent for companies which have experienced a significant drop in price and exhibit multiple contraction. Companies with already depressed multiples tend to be less volatile than the broad market and would be expected to go down less when the broad market is falling since they have already “sold off”.
Covered Calls
During a recession implied volatility will expand, increasing option premiums. The increased premium collected through option writing should result in increased cash flow and enhanced hedging properties. This is an ideal environment for the Covered Call strategy.
The Covered Call strategy and option writing in general can serve 2 purposes during a recessionary market:
Protective Puts
While the securities with in your portfolio may be selected based on their anticipated resilience in a recessionary market, protective puts can also add to its steadfastness during a market decline. The challenge for the put purchaser is the very factor that makes option writing attractive, increased premiums due to the uncertain market environment. That said, there strategies at our disposal designed to help offset the cost of an expensive contract. For details on the Protective Put strategy click here.
It should be noted that the Covered Call, Collar strategy and Protective Put are all permissible in a registered account, however the Bear Put Spread is limited to non-registered, margin accounts.
Conclusion
As markets continue to climb higher, it’s important for investors to remain pro-active in how they are managing their portfolios. As the old saying goes, “the trend is your friend” however, being prepared to adjust and adapt accordingly as conditions change will go a long way towards capital preservation. This involves adjusting the asset and sector allocation of your portfolio, perhaps raising some cash to keep “powder dry” for new opportunities. And last, but not least, putting your options education to work by implementing strategies designed to manage risk and enhance returns under challenging market conditions.
CEO and Director of Business Development
R.N. Croft Financial Group
Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.