How to protect yourself against a volatile stock market

  • By Al Root,
  • Barron's
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It’s said the stock market cycles between fear and greed.

Fear is winning lately. The S&P 500 (.SPX) is down over 4% and the Cboe SPX Volatility Index (.VXB) is up 18% in December. Even when the market appears calm, intraday stock moves have been significant. On Tuesday, for instance, the stock market closed down 0.04%, but swung over 2% during the day.

On Wall Street, volatility is synonymous with risk. High volatility in a stock means there’s more chance you’ll find yourself needing to sell it at a low price to raise money. Still, volatility measures are only mathematical expressions of real risks in the marketplace.

In a report published Wednesday, HSBC (HSBC) grouped risks into three categories: event risk, market risk, and liquidity risk.

Trade tensions and eurozone growth were two of the event risks the bank highlighted for 2019.

Trade fears have been with us all year. Currently, Chinese and U.S. officials have until early March to work out a deal before the U.S. ratchets up tariff rates from 10% to 25%.

European growth has decelerated this year, and Britain’s wobbly effort to exit the European Union raises the risk of a further slowdown. HSBC worries these issues could pressure the euro next year. A lower euro could hit U.S. companies’ sales on the continent.

A market risk HSBC frets about is the valuation impact of falling margins. The broker points out that profit margins are at an all-time high and faster wage growth could make it difficult to maintain them. Falling margins would not only hit earnings, but could compress market multiples, too. The S&P 500 trades for about 15 times 2019 earnings. That’s in line with history, but the S&P 500 traded all the way down to about 10 times forward earnings during the financial crisis.

Finally, HSBC examines liquidity risk. S&P 500 companies have added over $1 trillion in debt over the past five years. Higher rates would hit earnings as corporations try to refinance their debt, with the potential for bond market problems to spill into equities. One third of all triple-C rated high-yield U.S. debt needs to be refinanced over the next four years. All that activity raises the chance of a hiccup in debt markets.

These are some of the risks driving current market volatility, but not everything investors need to worry about.

Consider idiosyncratic risk. It refers to a risk specific to only one stock or one portfolio of stocks. For instance, what happens if Facebook CEO Mark Zuckerberg gets hit by a bus. No one wants that to happen, but it illustrates a risk unique to Facebook (FB). Zuckerberg holds 77% of the Class B stock that counts for 10 votes per share. That Class B stock accounts for 51% of the total shareholder votes.

Facebook has been buffeted by concerns about data privacy that have taken the stock down nearly 20% year to date and 35% from its 52-week high. It is trading at 16.7 times next year’s estimated earnings per share. That’s close to an all-time low even though revenues are growing over 20% a year.

That’s cheap, which is one of the best ways to protect yourself against risk.

Micron Technology (MU), Baxter International (BAX), and Darden Restaurants (DRI) are three other S&P 500 stocks from different industries that combine low debt, low volatility, and good value. That is to say they are trading at a discount to the market and their own history.

Micron stock trades for three times trailing earnings and has no net debt. Baxter has paid down debt significantly over the past five years. Darden has also paid down debt and is less volatile than the overall market.

Of course, this is just a starting point when looking for lower risk stocks.

As a further protection against risk you can also buy assets that are positively correlated with risk. Purchasing the VIX (.VIX) or stock options are two alternatives. Generally those types of assets make up a small portion of a portfolio and they may be only for investors who can stomach all this volatility.

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