As investors prepare for any utterance of the words "taper" or "tighten" from Federal Reserve Chairman Ben Bernanke, it's a good time to take a step back and reconsider portfolio allocations.
Which sectors stand to gain or lose the most? Developed or emerging markets? High-yield corporate bonds or investment-grade Treasurys?
Fortunately, it's not hard to imagine how markets will react to stimulus reduction:We got a glimpse of that reaction in late May and June when Bernanke simply alluded to tapering in the latest minutes from the Fed's policy arm, the Federal Open Market Committee (FOMC).
So what did that preview tell us when global financial markets briefly went haywire?
First and foremost, it told us which sectors to avoid. For the most part, it's the usual suspects:real estate, energy and consumer cyclicals—especially retail and leisure/recreation.
Those FOMC minutes were released on Wednesday, June 19, so I assessed the return on more than 50 ETFs—each as a proxy for a sector, asset class or size/style bucket—from the previous day's close (June 18) to the end-of-week (June 21) close.
Of course, factors other than "taper-talk" were at play over that time period as well, but the insight is useful nonetheless.
Building and construction was among the biggest losers. Mere whispers of a reduction in quantitative easing caused the PowerShares Dynamic Building ' Construction ETF (PKB) to stumble more than 6.50 percent over a few days.
When the Fed talks about tapering QE, it's talking about reducing its monthly purchases of mortgage-backed securities and Federal Reserve notes.
As we can see below, it makes sense that building and construction would be hit hardest.
|PKB||-6.51%||Building ' Construction ETF|
|Lumber Liquidators||-13.31%||Wholesale hardwood floors|
PKB's performance was dragged down by some of its largest holdings such as Pulte Group (PHM), one of the nation's largest homebuilders, and Lumber Liquidators (LL), a hardwood floor company that's at the intersection of basic materials and homebuilding—an unfortunate place to be when stimulus is slowing. Both holdings were down more than 12 percent over the observation period.
After the mid-June sell-off, Bernanke was eager to clarify that tapering is not the same as tightening (raising interest rates). He's right; they're not. They do, however, represent different degrees on the same spectrum.
As the diagram below explains, energy is another common victim of rising rates and/or slowing stimulus.
If you expect the economy to grow faster than consensus expectations, going long energy is not a bad play.
However, when the Fed steps in to raise interest rates and slow economic growth, the popular adage "don't fight the Fed" comes to mind. Even if fundamentals appear strong, betting against the Federal Reserve has generally been a losing wager.
Unsurprisingly, energy exploration and production—a higher-beta subset of the broad energy sector, was hit hard by Bernanke's statements:The SPDR S'P Oil ' Gas Exploration and Production ETF (XOP) fell 5.28 percent over the observation period.
Another casualty of Bernanke's "taper" talk was the PowerShares Dynamic Leisure and Entertainment (PEJ). Some of PEJ's biggest holdings were hit hard, including Las Vegas Sands (LVS) and Wynn Resorts (WYNN), which were down 8 percent and 7 percent, respectively.
|PEJ||-4.83%||Leisure and Entertainment ETF|
|Las Vegas Sands||-8.38%||Accommodations, gaming, entertainment|
|Wynn Resorts||-6.90%||Accommodations, gaming, entertainment|
|Starwood Hotels ' Resorts||-6.59%||Luxury Hotels|
Amid the carnage, where does one find shelter?
Let's use our mid-June preview to see which sectors declined the least.
Using the SPDR S'P 500 ETF (SPY) as a proxy for the U.S. stock market, U.S. equities fell more than 4 percent, but some sectors were significantly more resilient.
The PowerShares KBW Bank ETF (KBWB), a portfolio targeted toward U.S. banks, barely fell 2 percent over the same period. The nation's biggest banks tend to be among the top performers in rising-rate environments.
There are no guarantees in investing, but the investment thesis for owning banks in a rising-rate environment is that new investments will bring in higher returns, profit margins on loans will increase and bond trading will be more profitable—all of which are supposed to offset losses incurred on outstanding low-rate loans.
Other financial ETFs were resilient in the downturn as well. The iShares U.S. Broker-Dealers ETF (IAI) and the iShares U.S. Financial Services ETF (IYG) each fell significantly less than the broader market.
The other safe haven in June's downturn was the health care sector. Health care is considered a "defensive" sector because demand for health care services tends to be independent of the state of the economy. When people are sick, they go to the doctor regardless of whether the economy is contracting or expanding.
Shifting To Fixed Income
In fixed income, the general theme is to stick with high-credit issues with little interest-rate risk. Portfolios with greater duration or lower-credit quality are bound to suffer more from tapering—a suggestion consistent with ETF returns.
Therefore, the safest place may well be investment-grade floating-rate notes. The iShares Floating Rate Bond ETF (FLOT), for example, emerged unscathed from the June sell-off:It actually generated a slightly positive return.
The opposite of that advice would be to invest in long-term corporate issues—which got slammed over the observation period. The Vanguard Long-Term Corporate Bond ETF (VCLT), for example, fell more than 5 percent in just a few days.
We could slice and dice the fixed-income market for more granular comparisons, but the results would be the same. Suffice it to say that prudence suggests reducing risk—both credit and interest-rate risk—within fixed-income portfolios before the next taper scare.
The final distinction to make is that, in general, the reaction to "taper talk" has been the typical "risk-off" trade. Accordingly, emerging markets were slammed in the sell-off.
To review, the taper preview in June taught us a few things.
When it comes to equities, avoid real estate (especially building and construction), consumer discretionary (especially leisure and recreation) and energy (especially explorers and producers).
Instead, consider exposure to banks or health care, and for fixed-income exposure, stick to short-duration, high-quality issues. And, of course, beware of the emerging markets.
At the time this article was written, the author held no positions in the securities mentioned. Contact Spencer Bogart at firstname.lastname@example.org or follow him on twitter @Milton_VonMises.
Permalink | ' Copyright 2013 IndexUniverse LLC. All rights reserved