The Wall Street scare that spooked investors in February proved to be a false alarm, showing how risky it can be to flee the stock market out of fear.
But it was the start of something.
Even though the selloff didn’t turn into a full-fledged bear market, stocks have entered a new, bumpier phase — as evidenced by Thursday’s 724-point decline in the Dow Jones industrial average.
“Volatility returned in the first quarter of 2018 with a vengeance,” says David Kotok, chairman and chief investment officer for Cumberland Advisors.
Less than three months into this year, investors have already witnessed more days in which the S&P 500 index has risen or fallen by at least 1% than in all of 2017. What’s more, the average daily swing in stock prices so far in 2018 has been three times wider than last year — meaning there’s a good chance that any given day might produce a triple-digit gain or loss in the Dow.
That volatility is likely to remain for the foreseeable future, market strategists say.
Why? For starters, at nine years old, this is the second-oldest bull market in history. And aging rallies have a way of getting jittery near the end.
Moreover, “the market is reacting to the uncertainty around this president’s style,” Kotok says, noting that the unpredictable nature of this administration — coupled with disruptive turnover among White House personnel — could be contributing to the market’s skittishness.
Plus there are plenty of fundamental reasons why investors are getting nervous. Among them: rising interest rates, which could increase borrowing costs for companies; rising inflationary pressures, which could force the Federal Reserve to hike interest rates even more; and fear of a trade war, especially now that the Trump administration is about to impose tariffs on Chinese imports.
Yet all the while, the bull market keeps plodding along, which means you have to find a way to smooth out the market’s bumps without slamming the brakes on stocks.
The good news: There are investments that act like shock absorbers if held within a diversified portfolio.
1. ‘Steady Eddie’ Stocks
The simplest strategy to reduce volatility in your portfolio is to stick with so-called Steady Eddies: shares of humdrum companies that tend to fall less when the market is down, but also rise less in euphoric times.
While this seems like a strategy tailor-made for rocky markets, there’s a strong case for owning these shares all the time. Academic research has shown that low-volatility stocks actually outperform the broad stock market over the long run.
Moreover, low-volatility stocks have outperformed the market in the two most recent major downturns for U.S. equities: the bursting of the dotcom bubble and the global financial crisis.
In the 2000-2002 tech wreck, for example, low-volatility stocks actually gained more than 6% while U.S. stocks fell by double digits.
• How to invest: There are a number of funds and ETFs that specifically focus on this low-volatility strategy. iShares Edge MSCI Minimum Volatility (ticker symbol: USMV), for instance, is a big, low-cost fund that invests in about 150 U.S. stocks that exhibit lower-than-average volatility while also enjoying strong profit and cash flow growth.
Among the top holdings of this fund are boring names like the medical instrument maker Becton Dickinson and the trash and environmental services firm Waste Management. In the 2008 stock market crash, Becton Dickinson fell only about half as much as the broad market while Waste Management shares actually gained value.
Thanks to these types of stocks, iShares Edge MSCI Minimum Volatility tends to hold up better in choppy markets. In months when the S&P 500 has posted losses over the past five years, for instance, this ETF has lost only about two-thirds as much as the market, according to the fund tracker Morningstar.
2. Dividend-Paying Stocks
Income-generating stocks have a built-in cushion: the dividends that they issue to shareholders.
If their share prices were to fall say, 10%, a dividend payout of 3% would alleviate some of that pain. In the 2008 market crash, for example, when the S&P 500 index lost a stunning 37%, dividend payers saw a much more modest 23% decline in total returns, softening the blow.
There’s another reason to embrace dividend payers at a time when market volatility is on the rise due to inflation fears: “Over the long term, dividends have done a good job of staying ahead of inflation,” says Jack Ablin, chief investment officer for Cresset Wealth Advisors.
Of course, dividend-paying stocks aren’t without risk. In the event the economy is about to slow, there’s a possibility that companies in weak financial condition could be forced to trim or suspend their payouts if business slows, as many banks did during the financial crisis.
That’s why “as you get later in the economic cycle, what becomes important is ultimately dividend growth,” says Mark Freeman, chief investment officer at Westwood Holdings Group, referring to companies that can consistently raise their payouts over time.
• How to invest: A good place to look for these types of dividend payers is in the SPDR S&P 500 Dividend ETF (SDY), which tracks an index of companies that have paid and increased their dividends for at least 20 consecutive years. Among the top holdings of this fund are two low-P/E stocks that have consistently boosted their payouts for more than three decades: AT&T and Exxon Mobil.
Why dedicate a small portion of your portfolio — say, 5% to 10% — to raw materials? For starters, commodities are an inflation play, as growing economic activity is likely to boost the price of natural resources such as oil and steel.
Plus, relative to stocks, “commodities have cheapened significantly,” says Jim Paulsen, chief investment strategist for The Leuthold Group. “Indeed, from their peak in 2008, the relative price of commodities has declined by more than 75%.” And relative to stocks, he adds, “the price of commodities is near a 50-year low.”
But the real reason to hold commodities is the diversification effect that they can have over a broadly diversified portfolio of stocks and bonds.
Paulsen looked at past inflationary periods — specifically, times when the economy was growing faster than the national unemployment rate (which is the case today). In such periods going back to 1970, the stock market has suffered losses in 34 out of 105 quarters, or roughly 33% of the time. But in those down quarters for stocks, “commodities delivered a positive total return about 75% of the time,” Paulsen found.
• How to invest: In our MONEY 50 list of recommended ETFs, there’s iShares North America Natural Resources ETF (IGE), which gives you exposure to energy and natural resources for the relatively cheap cost of 0.48% of assets a year.
4. Bargain-Basement Stocks
For years, stocks have been trading at lofty prices. But investors have argued that high price/earnings ratios aren’t a problem for the market, since inflation is at historic lows — and low inflationary periods have historically coincided with higher-than-average P/E ratios for equities.
However, if consumer prices and interest rates are moving higher now, causing choppiness in the market, that valuation argument loses some of its punch.
This is why Lewis Altfest, president of Altfest Personal Wealth Management, says investors ought to “trim some of the high-flying stocks with high P/Es” from their portfolios.
History says that’s good advice. Normally in a market selloff, stocks with high P/E ratios tend to fall more because they’re starting off at loftier levels. This was the case with frothy tech stocks in the dotcom crash in 2000 and expensive real estate-related equities in the mortgage meltdown of 2007.
• How to invest: Use the equity portion of your portfolio to invest in undervalued stocks. In our MONEY 5o list of ETFs, there’s the PowerShares FTSE RAFI U.S. 1000 ETF (PRF). This fund owns blue-chip stocks that are relatively cheap based on fundamental factors such as their earnings and dividends. Indeed, the average holding in PowerShares FTSE RAFI sports a P/E ratio of less than 15, which is 15% cheaper than the broad market. The fund has outperformed more than 90% of its peers over the past decade.
5. High-Quality Stocks
If investors are worried that stocks will gyrate on economic fears, than the smart play is to recession-proof the stock portion of your portfolio.
In addition to low-volatility and lower-priced stocks, history says that high-quality stocks — or shares of dominant companies with strong balance sheets and little debt — are able to withstand stormy economic times better than the market as a whole.
What’s more, high-quality companies also tend to perform better in the latter stages of a bull market, while speculative low-quality stocks thrive at the start of an economic and market cycle.
• How to invest: PowerShares S&P 500 Quality Portfolio (SPHQ) “invests in profitable firms with strong balance sheets and conservative operating asset growth,” noted Morningstar analyst Alex Bryan in a recent report. These are companies like Visa, Procter & Gamble, and 3M. As a result, “it should hold up better than most of its peers during market downturns and offer attractive performance over a full market cycle.”
Over the past five years, PowerShares S&P 500 Quality has matched the performance of the broad stock market, posting gains of more than 14% a year. Yet in those months when the S&P 500 lost value, this fund fell only around three-quarters as much, according to Morningstar.
“The types of quality stocks the fund targets are unlikely to offer eye-popping returns,” Bryan wrote. But the fund “should reward patient investors with a better risk-reward profile than the broader market over the long term.”