The stock market is due for a fall, but those who have been waiting for that more substantial pullback have missed out on a big rally already this year.
The question for many traders and investors has been how to keep portfolios exposed to more potential upside, while trying to stem some of the downside risks. Market timing is unreliable and hard to repeat consistently, so some experts are advising clients to make more nuanced changes to their portfolio.
In preparation for a possible downside move in stocks, some Wall Street experts are looking at the types of stocks that tend to hold up better than the overall market on a relative basis. One place that is getting more attention these days is "high quality" stocks. In the fund management world, "high quality" refers to stocks that exhibit certain characteristics that distinguish them from the broader market.
Some of those positive factors include things like lower levels of debt on a company's balance sheet, higher return on equity (ROE), positive profit growth trends, etc.
Wells Fargo's Head of Equity Strategy Chris Harvey is keeping a close eye on how these types of stocks perform.
"In an environment where everything is expensive, we recommend client portfolios designed to participate on the upside, but really focus on the downside," says Harvey. "We believe the best risk-reward is in higher quality stocks."
One of the ways investors can take a view on these types of stocks is through factor-based, exchange traded funds. BlackRock's iShares Edge MSCI USA Quality Factor ETF (ticker QUAL) has $3.7 billion in net assets, and invests in mid to large cap U.S. stocks that exhibit a slate of "high quality" fundamental characteristics. Harvey notes that the year-to-date performance of this ETF is almost identical to the S&P 500, and has either matched or outperformed the broader market during the 5 weakest days of 2017 so far.
Brown Brothers Harriman Chief Investment Strategist Scott Clemons is also focused on specific parts of the stock market as a way to mitigate risk in a potential downturn. He likes companies that have the ability to accelerate share buybacks in the event of a market correction.
"This doesn't put more money directly into your pocket as a shareholder," says Clemons. "But it does increase your ownership stake, and does so in a tax efficient way."
Clemons is also looking at options-related strategies, such as covered call writing. In other words, selling options that give others the right to buy shares you currently own at higher prices. The cash you get from the sale of those options can help partially offset any potential downside moves in your stock holdings. However, if stocks continue to rise, others will have the right to buy your stock at a predetermined price, which caps how much upside you can participate in.
Many financial advisors are looking to take advantage of a possible downturn in stocks.
"I wouldn't be surprised to see a pullback, which as a long term investor, I'd selectively use to increase exposure," says Hightower Treasury Partners Chief Investment Officer Richard Saperstein. "We're experiencing rising earnings, elevated profit margins, a global synchronized recovery and the potential for tax reform."