A simple strategy to position your portfolio for a recovery

Diving into the worst-performing sectors isn’t for the faint-of-heart, but it can produce more impressive returns on the upswing

Person catching upward-stabbing arrow with a butterfly net

(Illustration by Iker Ayestaran)

An inordinate share of the money made by investors in a typical five- to 10-year market cycle materializes in the six months following the bottom. That’s something for Canadians to keep in mind, considering that in January, our stock market entered bear territory, down more than 20% from its peak. In fact, the same is true of most major equity markets around the world, with the notable exception of the United States.

So where should you begin to allocate your risk capital if you anticipate better times ahead? Classical portfolio theory holds that different sectors and asset classes outperform at different stages of the economic cycle. For example, interest-rate-sensitive income stocks and bonds tend to do well coming out of the trough, and more cyclical companies excel later on as the recovery gains steam.

Trying to time these shifts is a fool’s errand. Hence, most investment professionals will tell you to stay diversified and invest for the long term. That means rebalancing your portfolio at least once a year, by selling some of the assets that have done best—and exceeded their model allocation—and buying more of your laggards.

Look back over time, though, and you’ll see many instances where the best choice was almost binary—the worst-performing asset class or sector in one year does the best (or close to it) the next. Take 2008: BRIC equities from the major emerging markets led the decline, falling 49%, while Canadian small caps, down 46%, represented a close second worst. In 2009, those losses reversed. Domestic small caps led the bounce with a 75% gain, while the BRICs were second best with a 64% climb.

This simple strategy, of overweighting whatever sector performed worst the previous year, is gaining credence among investment pros. “You can do this,” says Hal Ratner, a senior investment analyst with Morningstar. “You have to be vigilant, but it’s an active strategy you can use.”

The idea that underperforming sectors eventually outperform is not new, but last year’s dogs are tending to rebound more rapidly than in the past, says Ratner. One reason is that global markets are more integrated and correlated than ever before. Moves in one part of the world can affect investors across an ocean. Throw in algorithmic trading, whereby machines buy and sell based on data, and you’re seeing much larger swings on both the upside and the down. For evidence, Ratner points to the way the rolling monthly trading volume of the Russell 1000 index has doubled in the past 20 years and become more spiky.

Roland Chalupka, Fiduciary Trust Canada’s chief investment officer, thinks these factors magnify the classic cycle of fear and greed. As soon as something starts going awry, investors tend to sell out of a stock or a sector quickly. When things get cheap enough, people start buying back into that market and then everyone starts to pile in.

So what should you favour now? Generally, it’s the more growth-focused areas, such as emerging markets, small caps and cyclical stocks, such as industrials, that get hit the hardest when a market falls. And then they rebound most strongly. More defensive securities, such as consumer staples, large caps and fixed income, perform the best on the way down, but they don’t rise as fast in a recovery.

It comes down to growth versus value, says Bob Swanson, chief market strategist with CI’s Cambridge Global Asset Management. In a falling market, you want the large-cap dividendpaying stock that has low beta (a measure of volatility), he says. When the cycle turns, the names that have been disregarded— the higher-beta cyclical names mostly, which are now value plays—rise faster.

Of course, if everyone followed this strategy, the markets would be less volatile than they are. “If only the markets acted as beautifully as this,” says Swanson. In reality, some sectors can stay low for long periods of time. The Canadian mining sector has been in people’s bad books for years, while energy shows few signs of rebounding after brutal performances in both 2014 and 2015.

Employing this strategy requires two things: patience and developing a view on the sector. Investors need to find out why something is down and whether it will stay low for long. If it’s simply a market overreaction, then that industry or asset class could rebound quickly; if it’s in a secular downturn, then it may not.

Chalupka uses technology as a good example of a secular decline. It went bust in 2001, and only became loved again in 2012 when the sector’s earnings caught up with valuations. It took about a decade for it to rebound, which is typical for industries in secular declines, he says. People are now trying to figure out what kind of decline the energy sector is in. With more supply than demand, Chalupka thinks that it will be hard for companies to post big returns in the short haul. If the fundamentals don’t change, it could underperform other asset classes for some time.

However, there’s less downside risk to buying a beaten-down asset class than an outperforming one (like health care in 2015). Oil and gas stocks are historically cheap, “so the risk of losing money is low,” says Ratner. He cautions, though, that “you do have to figure out what the stimulus will be to cause prices to rise.” Ratner suggests owning shares with secure dividends so at least you get paid while you wait for things to turn.

Much as advisers cling to the long-term view of portfolio management, there’s something to be said from jumping out and in of over- and underperforming asset classes, at least with money you can afford to put at greater risk. “Buy something that’s comparatively cheap,” says Ratner. “The risk is relatively low and the chances for a payoff become skewed more to the upside.”