March 9, 2017 PORTFOLIO PROTECTION TECHNIQUES By Mike Halloran, CFA Investment Strategist

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1 March 9, 2017 PORTFOLIO PROTECTION TECHNIQUES By Mike Halloran, CFA Investment Strategist The stock market has been on a historic run higher since last fall. The good news is that global economic growth is improving and we ultimately see further gains for the bull market that started in However, the market is currently overbought on many metrics we follow, and we think it is prudent to review, and possibly implement, portfolio protection techniques. This piece discusses some of the more practical portfolio hedging techniques. Stocks have reached overbought levels on many of the metrics we follow. When stocks advance well above their moving averages or reach extremes on their 52-week rate of change, they typically experience a correction or a consolidation over time. The chart on the right shows that we are in a region where corrections have historically occurred. We also see early signs of rotation from the cyclical sectors to the defensive sectors, which suggests a consolidating market. Stocks are Reflecting a Synchronized Global Economic Expansion: The global economy has been experiencing a synchronized expansion that began around the middle of last year. The major global economic indicators we follow including business surveys, confidence readings, and leading economic indicators are at healthy levels and show broad participation across countries. This suggests further profit growth will support stocks, and ultimately, further stock market gains. Major corrections or bear markets are typically associated with recessions and tight central bank monetary policy (figure on the right). While the Federal Reserve has begun raising interest rates off the zero bound, monetary policy remains accommodative in the U.S. and very accommodative on a Page 1 of 5

2 global basis. Consequently, we are just anticipating market consolidation, and are not calling for an end to the bull market that started in March of Corrections and subsequent market recoveries have happened quickly since the bull market started in And significant moves into and out of cash to protect portfolios requires two correct decisions that are very difficult to achieve. Considering that we ultimately see further gains for stocks, we are recommending making portfolio adjustments and rebalancing, rather than making major shifts into cash or bonds. Rebalance Your Portfolio: In multi-asset class portfolios, we recommend periodic rebalancing. Academic studies show that it s reasonable to rebalance a broadly diversified portfolio on an annual or semiannual basis, with rebalancing at 5% of target thresholds. With the recent move higher in the market, stocks may now be too large of a percentage of overall portfolio assets. Rebalancing could lock-in some of the recent gains and potentially lower the overall risk of the portfolio. Check the Beta of Your Portfolio: The beta of a portfolio or stock just measures the movement of the portfolio or stock relative to the overall market. A beta of 1.0 implies the portfolio or stock moves in lock step with the market. A beta greater than 1.0 implies the portfolio or stock will see a move greater than the market. For example, if the stock market falls 1.0%, a portfolio with a beta of 1.2 would see a loss of 1.2%. Conversely, a portfolio with a beta of 0.8 would only see a loss of 0.8%. Defensive sectors including Consumer Staples, Health Care, Telecom, and Utilities are low beta sectors with defensive earnings. The companies in these sectors produce goods and services that are more of a need than a want. Consequently, their earnings are steadier and hold up better during tough economic times. These stocks tend to outperform during corrections when markets are anticipating increased economic uncertainty. Cyclical and interest rate sensitive sectors including Materials, Energy, Industrials, Technology, Financials, and Consumer Discretionary are higher beta sectors with earnings that fluctuate more with the economic cycle. These stocks tend to underperform during periods of market uncertainty when stocks are anticipating weak earnings S&P 500 Economic Sector and Corresponding Beta Page 2 of 5

3 The following table shows the change in the value of a $100,000 portfolio after a 10% market correction. Included is a high beta portfolio (large weights in Financials, Energy, Materials, Consumer Discretionary, and Industrials), a market-weighted portfolio, a low-beta portfolio (large weights in Health Care, Telecom, Utilities, and Staples), and a market portfolio that has 20% cash. Reducing the portfolio s beta (and risk level) can be accomplished by increasing defensive sector weights or by increasing the cash weighting. Portfolio Beta Value Notes Market 1.00 $90,000 Portfolio value after a 10.0% market correction. High Beta 1.15 $88,500 High Beta loses more than market during a correction. Low Beta 0.70 $93,000 Low beta loses less than market during a correction. High Cash 0.80 $92,000 Portfolio beta drops as cash is increased. Diversify Into Other Assets: We are also major proponents of diversifying across asset classes. The following chart shows the yearly returns for different asset classes and includes the returns associated with a well-balanced portfolio (includes large and small U.S. stocks, international stocks, REITs, U.S. bonds, alternatives, and cash. As can be seen in the chart, the welldiversified balanced account obtains solid long-term returns, while reducing return volatility. Page 3 of 5

4 Add or Increase the Weighting of Non-Correlated Assets: During the last significant market correction in early 2016, gold, the U.S. dollar, bonds, and TIPS (Treasury Inflation Protected Securities) held up much better than stocks, as shown in the table below. These assets have demonstrated a negative correlation to stocks in recent years and can be readily owned through exchange traded funds (ticker symbols given in the table). Asset Correlation with Stocks Return During Last Major Market Correction 11/30/15 2/11/16 Notes S&P % Gold % Return shown for gold ETF symbol GLD. Dollar % Return shown for dollar ETF symbol UUP. Bonds % Return shown for bond market aggregate ETF symbol BND. TIPS % Return shown for TIPS ETF symbol TIP. Stop Losses: Stop losses involve picking a price level ahead of time, at which you would no longer want to hold a security, and then selling it if this price point is breached. By establishing the stop-out point ahead of time, you can take the emotion out of selling a security if the stop point is breached. Stock prices typically reflect news that is yet to be publicly announced and stop losses are a very effective way to minimize losses before the bad news is announced. It is also an effective tool to use for stocks that you have a low conviction level on or stocks that are not core long-term holdings. Calls, Puts, and Collared Positions: Selling a call option creates an obligation to sell the underlying security at the strike price if the option is exercised. A premium is paid for taking on the risk associated with the obligation. Selling call options on securities that you feel are expensive can provide additional income for a portfolio. The risk is if the security trades above the call strike price and the security gets called away (capped upside). Buying a put option gives you the right to sell a given stock at a certain price by a certain time. Put options provide portfolio insurance by limiting downside risk but comes at a price the put premium. In certain circumstances, it may make sense to buy a put and offset the premium by selling a call on the same security a collared position. This provides the downside protection of the put but also caps the upside if the stock rises above the strike price of the call option. Disclaimer: Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment. This report is provided for informational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis. Page 4 of 5

5 Options may not be suitable for all investors, and there are significant risks inherent in the use of options, even when options are used for hedging purposes. Janney Montgomery Scott LLC does not provide legal tax or accounting advice and the information contained herein should not be construed as such. Investors should be aware of potential risks associated with option investing. Page 5 of 5