The Flight To Safety In Turbulent Times

The following post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga.

While the fourth quarter of 2018 saw stocks wobble, risky assets have performed exceptionally well over the past 13 months or so, pushing valuations for both stocks and bonds to the upper end of historical ranges. Looking at data stretching back to 1990 for some clues toward valuation, equities stand at the 83rd percentile using the price to earnings multiple, and bonds are at the 94th percentile using yield to worst, suggesting that each asset has been richer at certain times, but are far from cheap.

2020 has brought new headline risks for investors to absorb, especially around the novel coronavirus, which started in Wuhan, China. By many accounts, Chinese authorities are taking aggressive measures to contain the outbreak and limit its contagion effects. These actions are likely helping to limit the negative humanitarian impact, but may also have a perverse effect on the economy as production remains limited for what increasingly looks like an extended time. This also impacts the supply side for many companies with sizable Chinese exposure. This backdrop does not necessarily spell the end of the bull market as global financial conditions remain loose, but it does make the case for investors to look for diversification options to complement their portfolios with stock and bond valuations high and volatility likely increasing.

Preparing for the Worst

• Investors have a multitude of options that deliver uncorrelated (or even inversely correlated) returns to equities ranging from the simple to the complex, to the manufactured. In today’s market, investors may benefit from recalling Occam’s razor when it comes to seeking a solution for their portfolios as simpler approaches may have greater benefits than sophisticated ones. First and foremost, complexity comes with a price whether that be higher expenses or a higher requirement for understanding the drivers of the diversification potential, and its ability to do so going forward.

Going with Your G.U.T.

• In the spirit of keeping it simple, one can look at three distinct assets – gold, utility stocks, and long-term treasurys – and examine their historical correlations to the S&P 500. Over the 8-year period illustrated below, gold has a 0.07 correlation, utilities a 0.23 correlation, and long-term treasuries a -0.32 correlation. While individually, these assets will see their correlations shift through time with utilities recently having a higher correlation and long-term treasuries a lower one, the trio of asset classes, together, delivers an average correlation of 0.00. Perhaps more importantly, all of the three have relatively stable volatilities and are uncorrelated with each other, making them attractive from a diversification perspective.

Gold, Utilities, and Long-term Treasurys have Low Correlation to Stocks
 

Source: Bloomberg Finance, L.P., as of February 1, 2012 to January 31, 2020. Gold represented by the LBMA Gold Price PM, Utilities represented by the Solactive US Large & Mid Cap Utilities Index, and Long-Term Treasuries represented by the Solactive US 20+ Year Treasury Bond Index. One cannot invest directly in an index.

Flight to Safety

• Since March 2015, investors have added over $179 billion to what Bloomberg Intelligence has classified as representing safe haven ETFs. This group includes funds offering exposure to gold, US treasuries and low volatility equities. Over this period, US treasurys have seen the greatest interest with over $105.6 billion of inflows, while gold has been the least with $19.1 billion of inflows.
• Flows across these 3 groups have averaged $3 billion monthly with US treasurys accounting for more than half of that, seeing $1.8 billion monthly. Both the cumulative totals and consistent monthly net flows highlight how ETF investors may be interested in potentially buffering their portfolios in the event of a sell-off. In other words, while safe havens saw an impressive $36.2 billion of inflows in the fourth quarter of 2018, activity was consistent and generally positive before and after this most recent sell-off.

Investors have been Adding to Safe Havens Even with Robust Stock Markets
 

Source: Bloomberg Finance, L.P., as of March 1, 2015 to February 14, 2020. Data represents the net flows of U.S.-listed ETFs that Bloomberg Intelligence has classified as Safe Haven ETFs including Gold, US Treasurys, and Low Volatility Equity.

What’s Next?

Heading into 2020, consensus among economists was that we should see an acceleration of global economic growth thanks to a combination of reduced uncertainty around trade, looser monetary policy, and a general pickup in activity, especially in the emerging markets. While this view may eventually come to fruition, it likely needs to be pushed out into the future thanks to the impact that the coronavirus will have on China and all of its related trade linkages. Relative to bonds, stocks continue to look attractive; however, the path forward looks increasingly volatile, making the case for introducing defensive exposures.

• Gold and treasurys offering diversification potential relative to stocks is intuitive, but utilities having a 0.23 correlation may be less so. In addition to generally stable revenue and cash flow streams, one driver is related to the profile of utilities being a sector with above-average dividend yields implying that a greater portion of an investor’s total return would come from income as opposed to capital appreciation, all else being equal. Another sector with high-income potential and interest rate sensitivity is real estate. However, real estate has a much higher beta, or sensitivity of its volatility, to the S&P 500 than utilities do. So while their most recent beta for real estate is below that of utilities, it is higher more often than not and does not offer the consistency that investors require when it comes to diversified exposures that are intended to be there for them when they need it most.
• A greater concern for utilities may be that related to their current valuation, they look expensive relative to history and the broader market. However, as previously noted, the market itself is at the top end of its valuation range. One could agree that out-of-favor sectors like energy may be a better buffer than utilities from a valuation standpoint, but that would be ignoring the impact that energy firms have a heavy reliance on the demand for petrochemicals, which would likely be negatively impacted in the event of a selloff. While investors should always be cognizant of the valuation they are paying for any asset, in today’s market, utilities are not necessarily in a position to perform differently than they have in previous pullbacks simply because they are trading richly relative to current sales and earnings.

Compared to Real Estate, Utilities have a Lower Beta to the S&P 500 on Average
 

Source: Bloomberg Finance, L.P. as of October 1, 2002, to January 31, 2020. Utilities represented by the S&P 500 Utilities Index and Real Estate represented by the S&P 500 Real Estate Index. One cannot invest directly in an index.

Implementation Idea

• The Direxion Flight to Safety Strategy ETF (FLYT) combines three asset classes with historically low correlation to stocks – long-term U.S. treasury bonds, utility stocks, and physical gold – to deliver investors with the potential to serve as a ballast in portfolios during times of turbulence and offer attractive total return and income opportunities in other times.

Definitions

• LBMA Gold Price PM: The LBMA Gold Price PM is the global benchmark price for unallocated gold delivered in London based on an auction set at 3:00 PM London time in US dollars.
• Solactive US Large & Mid Cap Utilities Index: The Solactive US Large & Mid Cap Utilities Index comprises those companies included in the S&P 500 in the Solactive GBS United States Large & Mid Cap Index that are classified as utilities.
• Solactive US 20+ Year Treasury Bond Index: The Solactive US 20+ Year Treasury Bond Index is a market value-weighted index that includes publicly issued US Treasury securities that have a remaining maturity of greater than 20 years. Eligible securities must be dominated in US dollars and have a current SOMA-adjusted amount outstanding of at least $250 million. Inflation-linked bonds, callable bonds, floating rate, fungible strips, principal-only strips, interest-only strips and local government bonds are specifically excluded from the available universe.
• S&P 500 Utilities Index: The S&P 500^® Utilities Index comprises those companies included in the S&P 500 that are classified as members of the GICS^® utilities sector.
• S&P 500 Real Estate Index: The S&P 500^® Real Estate Index comprises stocks included in the S&P 500 that are classified as members of the GICS^® real estate sector.
• S&P 500 Index: Standard & Poor’s^® selects the stocks comprising the S&P 500^® Index on the basis of market capitalization, financial viability of the company and the public float, liquidity and price of a company’s shares outstanding. The Index is a float-adjusted, market capitalization-weighted index.

An investor should carefully consider a Fund’s investment objective, risks, charges, and expenses before investing. A Fund’s prospectus and summary prospectus contain this and other information about the Direxion Shares. To obtain a Fund’s prospectus and summary prospectus call 646-846-0181 or visit our website at www.direxion.com. A Fund’s prospectus and summary prospectus should be read carefully before investing.

Solactive AG is not a sponsor of, or in any way affiliated with, the Direxion Flight to Safety Strategy ETF.

The Fund is an actively managed ETF that does not seek to replicate the performance of a specified index and is not required to invest in the specific components of its benchmark index.

Risks – An investment in the Fund involves risk, including the possible loss of principal.  There are risks associated with the Fund’s investment in gold, U.S treasury bonds, and utility stocks.  The value of gold has historically experienced extended periods of flat or declining prices in addition to sharp fluctuations, which may result in significant volatility and potential losses to the Fund. A security backed by the U.S. Treasury or the full faith and credit of the United States is guaranteed only as to the timely payment of interest and principal when held to maturity. The market prices for such securities are not guaranteed and will fluctuate. Utility companies are affected by supply and demand, operating costs, government regulation, environmental factors, liabilities for environmental damage and general liabilities, and rate caps or rate changes. Additional risks of the Fund include, but are not limited to Commodity-Linked Derivatives Risk, Counterparty Risk, Cash Transaction Risk, Other Investment Companies (including ETFs) Risk, Subsidiary Investment Risk, Interest Rate Risk, and Tax Risk. Please see the summary and full prospectuses for a more complete description of these and other risks of the Fund.

Distributor: Foreside Fund Services, LLC.

The preceding post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga. Although the piece is not and should not be construed as editorial content, the sponsored content team works to ensure that any and all information contained within is true and accurate to the best of their knowledge and research. This content is for informational purposes only and not intended to be investing advice.