Investing in a Black Swan Event

The investment management industry is on a constant lookout for signals regarding the direction of the market. Signals and screening for them is a constant endeavour and it has its benefits and pitfalls. Signals are best when you have an edge, or at least a perceived edge. Screening is as good as the criteria you are asking for and in what amount, duration, and combination. Screening is a recipe of sorts, where pitfalls can occur, like using too much of one ingredient or not enough of another might create an undesirable outcome. 

This virus is the definition of a Black Swan event. Investopedia’s Black Swan definition is on point and feels like the virus itself. 

A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight.

Investopedia

This leads me to the business cycle and sector rotation. Sector rotation has been a long discussed and implemented style of investing. Most of the time it is based on quantitative factors, and rightfully so. It’s difficult to know exactly where we are in the business cycle. However, today we find ourselves in a sort of  virus-inflicted recession with the economy locked down and money spent only towards our most basic needs. 

Fidelity has done analysis over the years on investing in the business cycle by applying a sector rotation asset allocation based on where we might be in the current business cycle. They have a great chart to illustrate which sectors outperform and underperform in every cycle phase. 

Last year Fidelity research had us in a late cycle and based on their research we should have seen strength in Materials, Consumer Staples, Health Care, Energy, and Utilities.

Performance of a one year period from data provided from our platform showed three sectors did outperform the SPY.

  • XLU +5.15%
  • XLP +4.81%
  • XLV +3.44%
  • SPY – 2.72%
  • XLB -9.02
  • XLE – 49.02%

However, the latest one month performance of XLB was +10.56% and XLE was +5.34% versus the SPY of +3.3%. So perhaps we may find ourselves in a late cycle phase that could be transitioning into a recessionary phase, if it hasn’t already.  

Fidelity’s latest piece mentions that we have extended our late cycle phase.

However, many economists are currently saying that we might have entered into a recession. If that is the case and we are in a recession or at least on the cusp of leaving the late cycle and moving into the recessionary cycle, then the sectors to consider overweighting are Utilities, Healthcare and Consumer Staples. And, I would add two additional sectors to this watchlist. 1) Technology, XLK and 2) Communication, XLC. Considering the work from home that most of us are doing, we are using more and more technology and communication systems to make this happen. Not to mention the entertainment factor of Comcast, Netflix, and Amazon Prime and all the news we consume from Twitter, LinkedIn, YouTube, and Facebook. 

Using our rating and ranking platform at PortfolioWise and taking into account the research from Fidelity, we agree on the sectors of choice, plus the two mentioned above: 

Given this environment of “shelter in place” because of this Black Swan event, it makes sense that these basic-needs sectors could provide a desirable outcome in your client portfolios. These are good candidates to add to your watchlist of ETFs.   

Fidelity Research: Business Cycle 

PortfolioWise

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