Prioritise quality companies. If an investor needs to take a defensive stance, it is worth turning to quality stocks, as their robust balance sheets and stable cash flows should insulate them from unforeseen downside risk. With this in mind, many of the largest technology and Internet stocks meet these criteria, while exposure to highly cyclical sectors and companies with excessive leverage should be kept to a minimum. Thus, in order to increase the resilience of your portfolios, you should focus on high quality companies, strong dividend payers and also not forget about regional diversification, as lower valuations and a weaker US dollar can also make global stock markets outside the US attractive.
The general understanding is that the market is likely to come out of the correction this year with expectations of a continued recovery in the second half of the year and a return to a bullish trend. This recovery is expected to help recoup portfolio losses from 2022.
However, there are several factors that pose risks to the market in the near future. These risks include the potential for a bear market, which could be triggered by inflation statistics such as the PCE index and strong labour market conditions. Another risk is the narrow scope of the current rally, where only some sectors have shown growth while others, including cyclical, defensive and growth sectors and assets such as bonds, have remained weak. There is also uncertainty about the timing and severity of a possible recession this year. The market is now looking at the likelihood of a moderate recession, which is already factored into current expectations and prices.
Once there is more clarity on these risk factors, portfolio allocation can be adjusted accordingly, considering both bonds and stocks, with a focus on the second half of the year and recovery of losses incurred in 2022. Two scenarios were considered for such an adjustment:
Scenario No. 1, the positive outlook, sees the market rising and breaking through significant resistance levels of 4200-4300 in the SPX index, which would lead to a rally. In this case, it would be prudent to increase long positions. Risky stocks should be held until they reach the most likely level of local recovery, and then locked in. For positions that still have potential, they should be held. The portfolio as a whole should then be rebalanced, creating a new balanced structure with a 25% allocation to cyclical assets, 35% to growth assets, 10% to protection and 30% to bonds.
Scenario #2, the negative outlook, assumes that the market continues to decline either from the current level or below 4100. In this scenario, protection should be strengthened by using inverse ETFs and reducing long positions (using stop losses) until the target stock is reached. This approach aims to minimise further drawdown until the correction is finally resolved in 2023.
The US stock market has thus experienced a strong recovery since the start of the new year, supported by a resilient technology sector, growth in the semiconductor industry due to AI development, a strong Q1 2023 reporting season, a pause in the Federal Reserve's rate hike, expectations of future rate cuts, lower inflation, a resilient economy, a smooth economic landing and a debt limit increase. While risks are still present, a focus on longer-term investment strategies can help investors benefit from the market's upward trajectory and continued recovery in 2H.
