After a mixed 2015, US equities had one of their worst starts into the New Year, declining in sync with global equity markets. Falling oil and commodity prices, weakening global economic data and concerns about central bank policies have further dented investor sentiment since the beginning of the year. Correlations have risen sharply in equity markets and across asset classes. The broad sell-off has been accompanied by a significant rise in volatility. Investors have switched to a risk-off mode. Is their stance justified?
Although the US economy is on a decent growth path, economic momentum has cooled recently, driven by weakening manufacturing activity and a collapse of capital spending in the energy sector. Nevertheless, labour market conditions have remained relatively strong. Yet the latest economic data and the market turmoil make it more challenging to predict future central bank policy. Will the Fed continue to raise rates and, if so, when? Also the US presidential election later this year may prove a lingering influence of market sentiment.
While investor sentiment is approaching panic levels, the recent sell-off may also provide investment opportunities for investors with the necessary risk budgets. Yet will these investors be adequately rewarded for the risks they take? In the current volatile environment, a broad portfolio diversification or a focus on uncorrelated strategies provides attractive risk/return characteristics. Market neutral long/short equity strategies, for example, aim to generate positive returns regardless of the market direction, while volatility and correlations with other asset classes are generally low. In addition to neutralising market risk, further systematic risk factors such as sector or style bets can be eliminated. This is achieved by pairing an attractive stock (long position) with an unattractive counterpart (short position) from the same sector. The two positions are given a similar weighting in the portfolio, thus ensuring that the strategy is neutral in terms of both the market and the sector. Regardless of how the market performs, such a strategy should generate positive returns as long as the long holdings outperform the short positions they are paired against (or vice versa).
The US equity market offers an attractive and huge playground to construct a portfolio of long/short pairs. An interesting stock pair in the US consumer sector is, for example, Foot Locker (long) and Ralph Lauren (short). Foot Locker is one of the leading sportswear and footwear retailers. The well-run company is benefiting from the “athleisure” trend – athletic apparel that’s worn outside the gym. Moreover, Foot Locker has a strong balance sheet and a well-managed inventory. Ralph Lauren, a clothing company, is mainly known for its Polo collection. Sale and factory sale have, however, damaged the image, which is reflected in declining sales volumes and margins. In the IT sector Red Hat (long) is a leader in the open source software space that could benefit from the convergence of public, private and hybrid cloud services. Against that, one could short Yahoo, a provider of online search and advertising services, which is struggling as growth drops on higher traffic acquisition costs, ad revenues wane and revenue may decline as the company is terminating a licensing agreement with Alibaba.
Especially in the current volatile and low interest rate environment, investors are well-advised to not put all their eggs in one basket. Alternative strategies such as the long/short approach just outlined could offer an interesting portfolio addition due to their low correlation with equity markets and other asset classes.