The stock market is going through a serious recession. It is beset by a concentration of additional risks and a high probability of losses. Yet companies and industries are weathering the crisis differently.
Understanding the main trends of this difficult process helps to form an optimal investment portfolio for the current conditions.
As noted in our material on investment strategies in the cryptosphere, an effective strategy must successfully combine both objective and subjective aspects. In the stock market context, the main objective factors reflect the current situation and include:
At the same time, subjective factors reveal the preferences and main goals of a particular investor, directly affecting the formation of the investment strategy and its subsequent implementation. In the context of the stock market, the list of the main subjective factors is as follows:
In recent years, investments in high-tech companies (Apple, Amazon, Netflix, Microsoft, etc.) have been particularly popular with investors. Their shares were commonly perceived as high-yield investments with minimal risk of losses or negative value fluctuations. Nevertheless, the current situation on the stock market is seriously different from last year.
The main reason was the restraining monetary policy of the FRS, manifested by growth of the discount rate. According to The Guardian, the Fed may raise this important indicator a total of 7 times during 2022 and the beginning of 2023.
In such conditions investors should reconsider their attitude to risk and choice of securities. Tellingly, it was the high-tech companies that suffered the bulk of the losses when the stock market crashed at the beginning of May this year. Therefore, it is advisable for a rational investor to conduct an independent analysis and exclude the influence of stereotypes relevant in other market conditions.
The market is experiencing one of its deepest recessions in the past 10 years. Specifically, over the past six months, the NASDAQ is down 24% and the Dow Jones Industrial Average is down 10% (according to Yahoo Finance).
The NASDAQ decline is represented by three main waves: January, February and April. The first of them is caused by the correction on the background of the rapid growth in 2021, while the last two reflect the increased risks in the market – both as a result of the US Federal Reserve’s tightening monetary policy and geopolitical tensions (especially after Russia’s invasion of Ukraine).
In the medium term, the current recession may be prolonged for the following reasons.
The global correction is not over. Despite the extremely negative effects of the coronary crisis on the global economy over 2020-2021, the NASDAQ index rose from 8,945.99 to 15,766.22 points – a 76% increase over 2 years. The stimulus funds were injected into the stocks of leading companies on a massive scale. The resulting gap between the stock market and the real economy is bound to cause (and is already causing) a downward bias in the stock prices of most companies.
Strengthening of the U.S. dollar. The so-called “American bailout act” of 2021 provided for $1.9 trillion in additional government spending (according to Deutsche Welle) to stimulate the economy during the crisis. As a consequence – the inflation rate this year reached a record for 40 years: 8.5% per year in March (according to the U.S. Federal Bureau of Labor Statistics). Under such conditions, the Fed is forced to systematically raise the discount rate in order to reduce inflation to an acceptable level. Its next increase by 0.5 percentage points in early May led to a shortage of available and cheap credit resources for investors, as well as to a proportional fall in the capitalization of many corporations.
Structural changes in the market. The rapid growth in the value of high-tech companies in the absence of sustained progress in other industries has caused a cross-industry imbalance in the securities market-the current value was not supported by fundamental factors. The resulting tech bubble could burst, and investors are looking to restructure their portfolios to avoid serious losses. Meanwhile, indices such as the NASDAQ (with a large share of IT and hi-tech companies) are showing larger declines than traditional industrial indicators.
Despite the extremely unfavorable environment for investors in 2022, not all industries and sectors of the U.S. economy represented in the stock market are experiencing the same crisis. Since the beginning of 2022, only the energy and utilities sectors have shown growth: +21.18% and +0.87% respectively (according to CSI Market). The situation in other sectors is critical: companies’ capitalizations have fallen from 7.9% (consumer goods, demand for which does not depend on the phase of the economic cycle) to 28.62% (technology companies).
In the energy sector, companies in the coal mining (+46.97% YTD) and oil and gas industries (+48.67%) were in the best situation. Software development (-34.84%) and cloud technology (-28.89%) are among the main IT losers of 2022. These industry peculiarities must be taken into account because the structure of stock market returns as of 2022 is radically different from last year.
While high-risk equity investments in innovative companies might be highly advisable in 2020-2021, short-term investors should take a more conservative approach for now. Even moderate returns with minimal risk can be considered an excellent result in a falling stock market. The basic principles of such an approach can be formulated as follows:
Most company securities from these sectors have not shown serious growth in the previous few years, despite strengthening fundamentals. Consequently, pent-up demand may allow stocks to reach higher valuations in the coming months. At the same time, the sanctions policy against Russian companies leads to significant changes in the market and additional interest in the products of energy and industrial companies.
Potential advantages: short-term investors can count on a yield that significantly exceeds the average level in the market – with a competent choice of investment objects.
Risks: implementation of this strategy requires constant monitoring of the market, and significant changes (for example, active involvement of energy companies from developed countries) may lead to losses.
With the recession and regulatory risks, new companies may find it difficult to attract investment and achieve sustainability. At the same time, corporations with extensive market experience are able to successfully leverage their assets and market reputation for stable and profitable development. For example, Chevron, a major energy company, has gained 41.24% of capitalization since the beginning of 2022, while The Coca-Cola Company, which represents the sphere of soft drinks, has reached a growth of 9.05% (according to Yahoo Finance).
Potential benefits: Buying securities of leaders in various industries (with the exception of IT and hi-tech) will significantly reduce the risks of a sharp stock price collapse in the event of negative external events (e.g. low economic growth or a further increase in the discount rate).
Risks: The investor should conduct additional analysis of the companies in question, because long-term leader status does not always guarantee high returns in subsequent months. For example, Pepsi Co, The Coca-Cola Company’s main competitor, has lost 2.6 percent of its value since the beginning of the year (according to Yahoo Finance). And this despite the fact that they belong to the same industry and are traditionally highly correlated with each other.
The management of some companies is more successful in using the current situation for strategic development, and timely investment in the shares of such companies can bring strategic benefits to many investors. For example, pharmaceutical giant AstraZeneca significantly strengthened its market position due to the vaccination against coronavirus and now continues to grow steadily around the world, providing a range of drugs (AstraZeneca has added 8.03% of its capitalization since the beginning of the year).
Potential benefits: Highly specialized investors can expect high returns even when targeting companies in low-growth sectors, as virtually every sector has companies with results well above the market average.
Risks: it is necessary to objectively assess those advantages that are already reflected in the market price (no possibility of obtaining additional income according to the theory of rational expectations) and those that are still ignored by other market participants (there is a possibility of profit). For example, the potential of another pharmaceutical giant, Pfizer, is already taken into account by traders, and its capitalization is down more than 16% since the beginning of the year.
Conservatism dominates almost all short-term strategies this year, but long-term investors can employ more creative and even aggressive strategies in search of the optimal balance between returns and risk over a chosen period (e.g., 3-5 years).
The current correction provides long-term investors with a unique opportunity to purchase securities of leading high-tech companies at relatively comfortable prices relative to their historical highs. Thus, Barron’s analyst Andrew Addison expects further declines in the quotations of the following tech giants: Amazon, Apple, Facebook, Google, Microsoft and Nvidia. The strategic positions of these corporations are not threatened, hence the long-term returns can be higher than the market average if these stocks are acquired in time (if the local bottom is reached in a few months).
Potential benefits: buying securities of IT-giants based on technical analysis and support levels allows to maximize long-term returns with minimal risk.
Risks: This strategy involves two groups of risks: the likelihood of buying stocks at a price well above the local low and the risk of serious problems forming that could weaken the leading technology companies. Technical analysis can be useful for managing the first group of risks, while fundamental analysis can be useful for minimizing the second.
Long-term investors also have the opportunity to form a balanced portfolio of securities of companies from different sectors and industries. By identifying the phase of the economic cycle and the most potentially profitable objects for investment, it is possible to buy shares of potentially undervalued market participants and maintain a balanced portfolio structure. For example, in a few months there may come a time for optimal investment in IT companies. Similar analysis is applicable to other industries and allows achieving the desired level of return.
Potential benefits: investors can achieve the most effective portfolio diversification by including the optimal number of stocks of companies from different industries at relatively low prices.
Risks: implementation of the strategy requires regular monitoring of prices and market trends in different industries. Inaccurate assessment of the macroeconomic situation and interindustry changes is fraught with losses.
The cyclic nature of the stock market leads to uneven concentration of risks at different time intervals. In particular, periods of rapid growth (market boom) and “cheap money” make more risky investments advisable, including new projects and developing sectors of the economy. Correspondingly, a recession and a “hard money” policy make more conservative investments to minimize risks advisable.
Potential benefits: a more dynamic approach allows investors to adjust the risk limit that is acceptable at a given stage. As a result, total investment income can be maximized.
Risks: this strategy requires accurate macro financial estimates and a sufficiently long time horizon (about 5 years) to cover all major phases of the economic cycle.
The stock market crisis has confirmed the need to reconsider the basic approaches to forming an investment portfolio. In particular, stocks of innovation leaders from the IT sector have been significantly losing value in recent years, while a number of industrial and energy companies have shown moderate growth.
In the short term, investors can focus on market leaders from traditional U.S. industries and trend-setting companies that are not yet fully valued by other market participants. Meanwhile, long-term strategies may involve building a balanced portfolio of leading companies from different sectors (including high-tech companies) in order to maximize long-term returns and better control
Oliver Green Investments Read 11min
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