BERLIN – For a lesson in stock market volatility, look no further than the first week of June. After the Dow Jones industrial average and Standard & Poor’s 500-stock index closed at record highs, those two market benchmarks, along with the Nasdaq Composite Index, each dropped about 3 percent during the next three days before a Friday recovery trimmed the week’s losses to less than 2 percent.
"We think volatility will increase as the year progresses," said Richard Bernstein, Merrill Lynch’s Chief Investment Strategist, who sees financial markets in transition from a speculative phase, fueled by the easy money of low rates, to a new stage that focuses more on corporate fundamentals.
During recent years, such rapid-fire ups and downs have been rare. But the big meltdown in February, when the Dow plunged more than 400 points following a dramatic slide in the Chinese stock market, jolted investors out of complacency, and there was another 2 percent tumble in March. And then came June.
The latest jitters appear to have been spurred by strong economic news (reducing the need for an interest-rate cut), surging Treasury bond yields (anticipating higher rates) and hawkish comments from Federal Reserve officials, who increasingly seem less worried about the health of the economy than about inflation, a concern that Federal Reserve chairman Ben Bernanke has called "somewhat elevated." The possibility that U.S. interest rates may not fall and that global rates may rise — June began with rate hikes in the European Union and New Zealand, and more may be on the way — suggests a period of continuing financial turbulence, says Bernstein.
Yet volatility, while disconcerting to many, can lead to opportunities for long-term investors who favor assets that the market has largely ignored, Bernstein says. In this current climate, he suggests five investment strategies.
High-quality bonds. A few years ago, investors who opted for the most speculative bonds could get yields 10 percentage points higher than those offered by the highest-quality issues. Recently, though, the spread has narrowed sharply. Meanwhile, the relative safety of U.S. Treasuries and top-rated corporate bonds adds to their appeal in volatile times.
Large-cap stocks. Looking at periods of rising volatility during the past two decades, Merrill Lynch analysts found that the highest-quality stocks, as measured by earnings consistency and other factors, tended to perform best. Large-caps today have several factors in their favor, says Bernstein.
Defensive sectors. Even when stocks fluctuate and the economy slows, demand for some goods and services barely declines. Health care and consumer staples tend to be resilient, according to Bernstein, and when money gets tight, discount retailers often prosper.
Developed and emerging markets. Countries such as Taiwan and South Korea, which have strong fundamentals and undervalued markets, may offer better opportunities in choppy markets than do such recent darlings as Latin America, China and India. But the developed world, including Japan, much of Europe and the U.S., could yield even bigger bargains.
Dividend income. Besides providing extra income, dividend-paying stocks can help to steady a portfolio during turbulent times.
All of these strategies look beyond current market bumps, and that’s always an effective approach when dealing with volatility, says Bernstein. "Extending your time horizon," he says, "is one of the easiest ways to limit the risk of a portfolio and increase wealth over the long term."
(The writer is a Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-9084.)