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Market volatility reigns, but buying opportunities abound

This year is off to one of the worst starts in the history of the Dow Industrials, and investors are increasingly concerned about wealth preservation in these turbulent times. Yet, a turnaround is inevitable, and investors are pondering the possibility of wading back into the market. The questions, as always, are what do I buy and when do I buy it?

Kevin Mahn, chief investment officer at Hennion and Walsh Asset Management, believes that the current chaos in the markets ought to reinforce the belief that asset allocation and diversification are crucial to long-term performance.

Diversification is key

"Over the last six years, we've been in a tremendous secular bull market run. And some investors have forgotten about the advantages of having a well-diversified portfolio. Even as we look at this very difficult start to the year, we saw certain areas in the market that performed better than others," says Mahn.

Source: Yahoo Finance, TradeStation



Currently in 2016, the telecom and tech sectors are among the least dirty shirts in the laundry basket, each slightly outperforming the S&P 500, which is down nearly -8% this year (not shown). However, utilities are the only major sector in the green, posting just over a 6% return in 2016.

"On the fixed income side, we've seen areas such as investment-grade municipal bonds and preferred securities perform well too," says Mahn. He continues, "It's not just picking between which U.S. large-cap stocks are going to perform this year, it's about building a well-diversified portfolio. And now more than ever, that's very important."

Increasing implied correlation among stocks has made stock picking more difficult than usual recently.

Crude contagion

It's no secret that the plunge in the price of crude has led not only the energy sector down, but has also led to general market contagion, driving down prices in global risk markets.

Source: Yahoo Finance, TradeStation

Yet, some larger energy stocks pay sizable dividends and will likely withstand the current credit crunch. Of his most recent energy market allocations, Mahn says, "We were very fortunate last week ... We came out with a new energy-based strategy with Miller Howard Investing that focuses on opportunities that we see in the North American energy supply chain."

Mahn says that oil will eventually decouple from stocks when oil prices finally bottom. However, he believes the bigger opportunity is in natural gas.

"Right now we're the Saudi Arabia of natural gas production, and we're the largest producer of oil and natural gas in the world," says Mahn. "So if you look at the opportunities that persist right now in the energy sector, we think there are some very attractive opportunities—as long as you don't stick to the commodity oil itself," he says.

 



Specific industry groups within the energy sector may offer additional opportunities for diversification.

Source: Yahoo Financial, TradeStation

"I think a nice blend would be between upstream and midstream companies—the midstream we always refer to as the toll-takers—those that store and transport the oil or natural gas. They do well regardless of the price of oil," says Mahn.

Although the drop in oil price is hitting fracking companies hard, they also produce 54% of domestic natural gas in the U.S., according to Mahn. "Natural gas demand is increasing worldwide. So, the frackers can still perform with oil prices low, but they can't perform well with oil prices low for too much longer," says Mahn.

Fracking is a highly capital intensive business. Accordingly, if preternaturally low crude oil prices persist throughout 2016, many will be forced to file for bankruptcy protection or otherwise sell assets. However, that does not necessarily mean all investors in these types of enterprises will lose their money, as secured bond holders typically receive some of the money back during bankruptcy proceedings.

In addition, buyouts of unprofitable fracking companies may become common.

Mahn says, "The newer fracking companies ... have taken out a lot of debt to be able to actually start drilling and find those opportunities. But not all companies have, so there is going to be a consolidation ... But those that survive this downturn are going to come out very plentiful in the end."

Diversification in the face of continued volatility

Though Mahn believes a stronger U.S. Dollar will continue to provide opportunities domestically, he stresses that geographic diversification is critical as well. "2016 is going to be the year where the baton is going to be officially passed from domestic markets to international markets in terms of total return potential. We like Europe more than Japan right now," he says.

Mahn doesn't expect the current volatility to go away any time soon, but that belief simply requires a different investment strategy. Much of the current market uncertainty is created by unease over the Federal Reserve's rate raising schedule.

Source: Yahoo Finance, TradeStation

"This volatility isn't going away. It's reigning supreme," says Mahn.

"You need to build into your portfolio areas that have performed well when the Fed has embarked upon a gradual tightening—such as the energy sector, such as the utility sector, such as investment grade bonds. All of those are areas that you can build into a diversified portfolio," says Mahn.