OPINION: How to fade risk as 'risk-on' stage nears its end

JOHANNESBURG - The global investment cycle is slowly but surely entering the “fade-risk” stage as signs that the “risk-on” stage in the global investment cycle is slowly grinding to an end are more evident by the day.

Although the US is effectively already in full employment, job openings rose to a record in January - an indication that the US, and in fact most developed economies, are rapidly approaching the late cycle stage in the global economic expansion.

But how do you fade your investment risk?

By far the most popular and easiest way to fade risk is by reducing the growth component (stocks and listed real estate-linked instruments) of your total portfolio in favour of relatively low-risk interest-bearing investments such as government bonds and cash or near-cash.

It is extremely difficult to call a top of a market or an end of a global economic upswing. We (and I specifically) simply do not know how the global economy will pan out in the coming quarters or years. I do, however, think there are ways to reduce the risk in investment portfolios without taking drastic action such as liquidating a significant portion of an investment portfolio.

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During a sustained global economic upswing, consumer discretionary stocks are the main beneficiaries as their profits rise as consumers have income available due to increased employment and wage increases, while they tend to save less.

They buy non-essential goods and services such as cars, durable goods such as appliances, clothes and other goods that they normally cannot afford when the economy slumps and they lose jobs.

Conversely, the demand for essential products - also called consumer staples - such as food, beverages and tobacco are relatively unaffected by the increase in consumer spending.

From a stock market perspective, consumer discretionary stocks outperform the market during an economic upswing, while consumer staple stocks underperform the market.

Consumer staple stocks, however, outperform the market during difficult economic conditions as consumers are unwilling to cut their expenditure on the essential products but cut down on non-essential products and services.

Coca-Cola is probably one of the best-known companies in the US's S&P 500 Consumer Staples Index.

Coca-Cola’s performance relative to the US market, as measured by the S&P 500 Composite Index during economic upturns and downturns over the past 20 years, as measured by the US unemployment rate (which is also an excellent indication of the financial circumstances of US consumers), speaks for itself.

The stock underperforms the market during economic upturns and outperforms during economic downturns.

Fading

What is important though is the fact that the US, for all practical purposes, finds itself effectively in a full employment position, meaning that the likelihood of further significant job creation in the US is fading.

That effectively means that Coca-Cola’s and other consumer staples companies’ underperformance relative to the broader markets and especially consumer discretionary companies is nearly over.

It is also important to note that according to Yahoo.com, Coca-Cola’s beta relative to the market (S&P 500 Composite) is 0.64. This effectively means that in a rising market, the stock will give you only 64percent of the overall market’s return.

But it is also important that in a declining market, the stock’s losses will be in the region of 64percent of that of the market in general. A similar behaviour can be expected of other global consumer staple stocks, as Coca-Cola is also quite representative of movements in the MSCI World Consumer Staples Index, especially since 2005.

The important message is therefore that whether the heightened volatility and slide in global stocks are just a downward correction from overinflated valuations or whether it heralds the next global stock market crash, investors and fund managers can fade the risk on their global equity exposures in developed markets by overweighting global consumer staple stocks in their portfolios while still maintaining a significant exposure to equities.

Ryk de Klerk was co-founder of PlexCrown Fund Ratings and is currently a consultant for PlexCrown Fund Ratings.

The views expressed here are not necessarily those of Independent Media.

- BUSINESS REPORT