There are plenty of reasons to be more cautious about the markets despite the flagship US stock indices, the S&P 500, continuing to hit new highs.

Investor nervousness is increasing. Just look at how many companies have recently beaten earnings forecasts, but their share prices have fallen as the market worries about near-term pressures or the loss of momentum in parts of their business.

Valuations are looking excessive in areas of the market and the meme stock phenomena we saw earlier this year would suggest a lot of people are treating investing as gambling which is a dangerous sign.

There are clear signs of froth in the markets and we’re also entering a seasonally choppy period for equities, so now is a good time to take a long hard look at your portfolio.

Rather than hide in cash, it would seem prudent to stay invested and merely adjust portfolios towards certain types of assets that could perform better on a relative basis if markets experienced a downturn. We offer some ideas later in this article. 

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WORRYING SIGNS

Market pullbacks or price corrections are a feature of how stock markets operate, but as the old saying goes, no one blows a whistle at the top, and often corrections are only noticed when they are well into their stride.

Conventionally a 10% to 15% drop in price lasting anywhere from a few days to months is considered a market correction, while a 20%-plus fall is considered an official bear market.

NEGATIVE EARNINGS YIELD

One intriguing indicator is the real earnings yield of the US market which has turned negative for only the fourth time since the 1980s.

This is a measure of inflation-adjusted earnings per share of the S&P 500 index divided by market value. Think of it as the reciprocal of the PE (price to earnings) ratio, adjusted for current inflation.

Up until the beginning of this year stocks weren’t yielding much but at least offered more than government bonds. But since the start of the year US consumer prices have been rising fast and in June hit 5.4%, the highest annual rate in 13 years.

Historically, every time the real earnings yield dipped below zero the stock market then had a meaningful correction.

WIDENING HIGH YIELD SPREADS

The difference or spread between yields on debt issued by the highest and lowest quality companies has historically been a good measure of investor risk appetite.

The high yield spread has narrowed significantly since March 2020 after the US Federal Reserve said it would include buying corporate bonds as part of its coronavirus stimulus plan.

After reaching a low of 3.03% in early July, the spread has ballooned out to 3.5%. Widening spreads could reflect increasing financial stress among the weakest companies or waning investor risk appetite.

In either case, a widening high yield spread is another sign that equity markets could be in for a period of weakness.

EXTREME VALUATIONS

While valuation indicators aren’t good timing tools, investors should always take note of extreme readings.

The cyclically adjusted PE ratio, also known as CAPE, was created by Nobel Prize winner Robert Shiller and although the system has its detractors, the principles underlying it are sound.

The latest reading is the highest since December 1999 just before the dot-com bubble burst.

Likewise, the indicator popularised by investor Warren Buffett, based on looking at market capitalisation to GDP, recently hit a new all-time high.

The explosive move from the lows in March last year is noteworthy and suggestive of irrational exuberance.

INVESTING BEING TREATED LIKE GAMBLING

One driver of the market’s steady climb has been the wave of younger people buying and selling shares for the first time.

This movement has been characterised by speculative money hoping for quick returns from companies with questionable qualities.

This trend has been accentuated by the FOMO (fear of missing out) dynamic and has been propagated by the increasing proliferation of stock-related chatter on social media platforms like Reddit and TikTok, with members of the public masquerading as investment gurus. Snappy videos feature individuals talking about investing as if you are almost guaranteed to get rich.

Suggestions that you must be ‘in it to win it’ seem more like gambling as there is certainly very little talk about analysing a company’s earnings, financial strength or valuation.

THE RISE OF THE SPACS

Another sign of increasing irrational exuberance has been the rapid growth in both Spacs – special purpose acquisition companies – and companies listing on the stock market.

Spacs are investment vehicles whose only assets are cash. Their goal is to find a business to buy, and that target effectively reverses into the Spac as a much faster way of joining the stock market than the normal IPO route, which stands for initial public offering.

A lot of investors have rushed to own Spacs in the belief they will buy great companies, in doing so they have bid up the price of the acquisition vehicle significantly above the value of its underlying cash.

Finding suitable acquisitions hasn’t been easy. Analysis by Goldman Sachs suggests that 400 US Spacs have a total of $118 billion cash yet to be invested in deals.

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WHAT COULD TRIGGER A MARKET CORRECTION?

There are two potential triggers which could trip markets up. The first is a growth scare, as the Covid Delta variant continues to spread, slowing the rate of economic recovery.

The valuation of the US equity market suggests investors are expecting a swift economic recovery, so any slippage won’t be taken well.

In this regard research from Bank of America highlighted that analyst expectations for GDP and earnings growth have stalled recently. If revisions go into reverse, watch out.

A second trigger is the chance that the Federal Reserve makes a policy mistake by letting core inflation get out of control, which would push up interest rates and make equities look less attractive. So far, markets seem to have bought the case made by the Fed that current inflationary pressures are transitory.

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THE SECTORS TO OWN – AND NOT TO OWN – IF THE MARKET SELLS OFF

Towards the end of 2019, prompted by a sense that markets had got ahead of themselves, Shares looked at which sectors performed best in a market sell-off of 10% or more and which performed best in the subsequent recovery rallies.

We had no more inkling than the next person that a crash was around the corner, and due to the specific nature of the pandemic the sectors worst affected were different to those which history told us to avoid. However, assuming the next sell-off is ‘normal’ – that is, triggered by growth and/or valuation concerns – this guide should come in handy.

During the three periods surveyed – mid-2011, mid-2015 to early 2016, and late 2018 – the FTSE 350 index dropped an average of around 17% in the downturns.

Using data from SharePad, our research showed that the least affected sector during all three market downturns was beverages, followed by software and computer services, personal goods, pharmaceuticals, and healthcare services and equipment.

At the same time, beverages and computer software captured a lot more of the upside when the market rallied post-crash, which makes them copper-bottomed bets if we do get another big correction.

In contrast, the sectors not to own in a market correction, according to historical trends, are automobiles and parts, industrial transportation and banks, as not only did they underperform on the way down, but they also lagged on the way back up. 

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WHICH STOCKS COULD BE AT RISK IN YOUR PORTFOLIO NOW?

If you believe that markets are heading for a correction, then it might pay to sell down any holdings in high beta stocks. High beta means they have greater sensitivity than the broader market, or in other words these stocks are more volatile.

While high-beta investments can outperform when the market is going up, losses can be greater than those of the market  in a downturn.

Screening platforms such as SharePad will enable to you find a list of high beta stocks, either versus their sector or the overall market.

Example of high beta stocks at the end of July included Rolls-Royce (RR.), Cineworld (CINE), SSP (SSPG), Carnival (CCL) and International Consolidated Airlines (IAG).

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WHICH INVESTMENTS MIGHT BE GOOD TO OWN IF THE MARKET STARTS TO FALL?

Shares has pulled together seven ideas for investments that have the right qualities to outperform the market in a downturn.

We’ve selected a mixture of stocks with defensive attributes, namely their products and services will be in demand during both good and bad economic conditions. The list also includes a property investor that owns medical centres and two income funds which invest in high quality cash-generative businesses.

British American Tobacco (BATS) £27.04

Investing in a company that specialises in the production of combustible and non-combustible tobacco products may not align with your investment morals. However, for investors who can look beyond these ethical considerations, British American Tobacco (BATS) has been one of the leaders in tobacco innovation and trades on an attractive price to earnings multiple of 7.8 and offers a prospective dividend yield of 8.4% based on forecasts for the 2022 financial year.

Earnings growth for the group continues to be underpinned by its considerable emerging markets exposure.

Cigarette customers are generally loyal to a specific brand and tobacco addicts would consider it non-discretionary spend. British American Tobacco has a reliable stream of cash flow, hence the generous dividend doesn’t ring the alarm bells you’d normally find with a yield of that level (i.e. questions about the sustainability of the payment).

The key risks to consider are failure to make good returns from investment in next-generation products such as vaping and regulatory/political interference across the tobacco sector.

Pennon Group (PNN) £12.65

Following the divestment of waste management services company Viridor for £4.2 billion in July 2020, Pennon (PNN) is now a focused water and waste-water company.

Pennon’s shares have a low beta which implies they should provide some protection in a falling market. Its services are non-discretionary with revenues remaining stable whether the economy is booming or contracting.

The shares offer a decent dividend yield of 3.3%, covered 1.5 times by earnings, and the company follows a policy of growing dividends in line with consumer price inflation plus 2%.

Law Debenture (LWDB) 749p

Founded in 1889, Law Debenture (LWDB) is an investment trust with a twist. As well as owning a portfolio of quoted UK stocks, the company offers professional business services to large corporates, law firms and banks which provides a steady stream of income.

The investment portfolio is managed by James Henderson and Laura Foll of Janus Henderson Investors and aims for long-term capital growth in real terms, i.e. ahead of inflation, together with rising dividends.

Among the top five holdings are Barclays (BARC), Rio Tinto (RIO) and Royal Dutch Shell (RDSB), which are all increasing their shareholder returns significantly this year.

For the first half of 2021 the trust reported a net asset value total return of 16.7%, comfortably ahead of the FTSE All Share Total Return index.

Primary Healthcare Properties (PHP) 160p 

This is a real estate investment company which specialises in owning primary care facilities, almost all of which have their rent
paid by the Government, meaning excellent visibility of revenues.

The primary healthcare sector played a crucial role in vaccinating patients during the pandemic. It is increasingly important in reducing the burden on hospitals as demographic trends mean more elderly patients with chronic illnesses.

Having recently brought the management of its estate in-house, costs are on a downward trajectory while rents are rising. During the first half of this year net rental income rose 4.5% while earnings rose 13%, enabling the firm to increase its dividend for a 25th successive year.

The shares trade on a 37% premium to Numis’ forecast net tangible asset value for 2021. However, we believe the stock is still worth buying given that earnings are uncorrelated to the market or the economy, most of its income stream is backed by the Government, and it offers a near 4% yield, making PHP a classic ‘safe haven’ for investors.

Troy Trojan Fund (BZ6CNS3) 

This fund is characterised by its distinctive method of investing that prioritises the avoidance of permanent capital losses. The team achieve this goal through cautious asset allocation and careful selection of high-quality companies.

Another feature of the strategy is the ability for the team to invest wherever they see the best opportunities.

The investment objective is to achieve capital growth ahead of retail price inflation over five to seven years.

Over the past three years the fund has delivered a return of 24.5%, handsomely beating retail price inflation of 7.2% and the FTSE All-Share total return of 6.3%, according to Lipper and Link Fund Solutions data.

The fund’s largest allocations are equities (45%) and inflation protected bonds (32%). The top holdings outside of bonds include software giant Microsoft, Google’s parent company Alphabet and gold bullion securities. The fund has an ongoing charge of 0.86% a year.

TB Evenlode Global Income Fund (BF1QMV6) 

Evenlode has a focus on high quality companies that can grow sustainably over the long term.

Through this sustainable growth, the companies should then be able to pay growing dividends over time, helping to compound long-term capital growth.

While the trade-off for this sustainability of income may be a lower yield (circa 2%), the potential consistency in the payments should make up for this.

In more difficult market conditions, investors will seek solace in stocks that have strong cash flows and that’s exactly the type of companies which feature in Evenlode’s portfolio.

Key holdings include Procter & Gamble which owns a broad range of consumer product brands including Pampers, Tampax, Ariel and Gillette; as well as Wolters Kluwer which provides professional information, software solutions and services in the health, tax, accounting, finance, compliance and legal sectors.

Guinness Global Income Fund (BVYPNY2) 

This fund has a concentrated portfolio of good quality, attractively valued companies, which offer a moderate dividend yield (the  fund’s yield is circa 2%) and good potential for dividend growth.

The managers seek out companies with at least 10 years of persistent high return on capital, strong balance sheets and the robustness to withstand economic shocks while delivering a sustainable, growing dividend.

The fund managers believe dividend payers outperform in the long term, and dividend growers even more so.

The fund typically has 35 equally weighted positions, which reduces stock specific risk. An equally weighted portfolio naturally gives greater weight to small and mid-caps relative to a broad index where big caps dominate.

The top holdings include tobacco manufacturer Imperial Brands (IMB), payroll processor Paychex and tech giant Microsoft.

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DISCLAIMER: Daniel Coatsworth who helped to write this article has a personal investment in Evenlode Global Income Fund.

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