You may remember the U.S. stock market’s “return to volatility” last year, but some aspects of the elevated price movement may surprise you.

Michael Stritch, the investment chief at BMO Wealth Management, discussed the changing investing environment, how his team of advisers was managing portfolios to reduce risk and how individual investors can do the same. He also talked about a renewed focus on U.S. large-cap stocks and pointed out two of his favorite stocks at the moment.

BMO Wealth Management has about $46 billion in assets under management. Stritch is based in Chicago.

Cutting risk as storm clouds gather

In an interview on Jan. 24, Stritch said BMO Wealth Management clients were expressing more concern during December (when the S&P 500 fell 14%) than during the declines in February and October. He felt at that time that the portfolios managed by his team were already “appropriately positioned,” with an emphasis on “U.S. equity markets on a relative basis compared with the rest of the world.”

In contrast, at the beginning of 2018, “as a group we were positioned for growth, risk-on. We were overweight equities and high-yield [bonds], with a particular focus outside the U.S. for equities,” he said.

Stritch explained that as the trade conflict between the U.S. and China developed and the Federal Reserve raised short-term interest rates, “risks were rising,” and his team “began to narrow our portfolio position, with a much more narrow focus on the U.S.,” he said.

BMO Wealth Management

Michael Stritch, chief investment officer of BMO Wealth Management.
Favored allocation and examples of two stocks

Stritch feels strongly that a long-term investor with a reasonable strategy should stick with it and not try to time the market. “If you miss a couple of big days, you run the risk of significantly reducing your long-term results,” he said.

According to research by BMO Wealth Management, the average annual total return for the S&P 500 for 20 years through 2018 was 5.63% (not a very impressive figure, but it does include the bursting of the dot-com bubble in 2000 and the financial crisis of 2008). But if you excluded the best 10 trading days for the index during that period, your average annual return would be only 2.0%. If you were out for the 20 best days, your average return would be -0.3%. A bad day may tempt you to time the market and then you might be “too late” in coming back. You might even be discouraged if you miss out on a quick recovery and then waste years waiting for the market “to come down again.”

Stritch favors large-cap U.S. stocks right now, especially those that have “stable growth models,” especially in the health-services, medical-devices and software industries.

Yes, you’ve been hearing about cloud-based computing for years, but it is still a compelling growth story. Stritch named Microsoft

MSFT, +0.91%

 as a prime example — the venerable software giant has certainly changed its image with investors in recent years, as it has moved customers to subscription-based distribution. The company said its third-quarter commercial cloud revenue rose 47% from a year earlier to $8.5 billion, while total sales were up 19% to $29.1 billion. Third-quarter earnings per share were up 36% from a year earlier to $1.14 (augmented, of course, by the cut of the maximum federal corporate income-tax rate to 21% from 35%).

Shares of Microsoft trade for 22.1 times the consensus earnings estimate for the next 12 months among analysts polled by FactSet. In comparison, the S&P 500’s forward price-to-earnings ratio is 15.4. For the index’s information-technology sector, the forward P/E is 15.9, and for the software subsector it is 20.9.

“Is it is the cheapest stock in the world? No, but people are willing to pay more for stability,” Stritch said.

Another example of a company with a sustainable growth model put forward by Stritch is AutoZone

AZO, -0.02%

For its fiscal first quarter ended Nov. 17, the auto-parts retailer’s sales were up 2% from a year earlier, while domestic same-store sales were up 2.7%.

AutoZone has “good stable sales growth and valuation compared with peers,” Stritch said. The company’s shares trade for 13.4 times the consensus EPS estimate for the next 12 months. This compares to forward P/E ratios of 19 for both O’Reilly Automotive

ORLY, -0.74%

and Advance Auto Parts

AAP, -1.98%

Stritch expects good news ahead for AutoZone. “Consumers are in good shape already. There can still be some good surprises in the first quarter, in tax-refund season,” he said.

‘Normal’ volatility

Stritch made some surprising points about the elevated level of price volatility for the S&P 500 Index

SPX, +0.85%

 during 2018. “December was dramatic, but if you look back over 2018, the number of days the S&P moved 1% was in the mid-60s,” he said.

That might seem to be a very high number of days with major swings for the broad market, but it is “right about average if you look back over the previous decade,” according to Stritch. “But the year before, it was less than 10 days plus or minus 1%,” he said, while calling the low volatility in 2017 “extreme.” For 2019 he expects the “normalized environment” for volatility to continue.

Of course, it is easy to say that we’re back in a normal environment for volatility, following a period of incredible support for stock prices by central banks around the world, through their policies of very low, or negative, interest rates and increasing liquidity. All that money needed somewhere to go, and U.S. stocks were very attractive when compared with bonds with low or negative yields.

But even if you understand that the recent volatility is what an investor can reasonably expect to be the norm, it isn’t easy for many investors to tolerate the higher levels of risk.

An asset class for lower risk

Stritch pointed to structured notes as an example of how BMO Wealth Management was helping clients reduce risk while still having exposure to stocks. For example, a structured note might offer an investor a downside buffer of 15%. This means if the underlying index were to fall 20%, the investor’s value would decline only by 5%. In exchange for that protection, the investor’s potential gain is capped at a certain percentage for the term of the note, which might be 12 to 18 months. Structured notes are continually issued and maturing, so investors have different choices as time passes.

Stritch stressed that BMO Wealth Management looks carefully at the issuers of the notes and the banks that underwrite them, to reduce credit risk.

“We pay a lot of attention and we are very particular with who we work with,” he said, while explaining that the bank underwriting the notes is “on the hook” for credit risk.

“We look for investment-grade credits, and model the relative attractiveness of any particular note relative to the issuer’s risk profile,” he added.

As they look ahead to a less certain economy and less accommodative policies among central banks, Stritch and his team have already started to lean more toward actively managed mutual funds. With the massive inflow of liquidity and such low rates for bonds, passively managed index funds has an overwhelming tendency to outperform actively managed mutual funds. But “in a sideways to downward market, asset manages who can be more flexible tend to outperform,” he said.

Don’t miss: These three ETFs have beaten S&P indexes while cutting risk

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