The introduction of fear to the financial market can be either a good thing or a bad thing—but seldom is it neither.
In the first case, increasing fear among investors in an environment characterized by fairly limited public participation (i.e., an uncrowded market), relatively unstretched valuations and plenty of liquidity often results in the “wall of worry” phenomenon in which stocks actually benefit from the rising fear levels.
In the other case, too much public participation, overvaluation and shrinking liquidity can combine to prompt intense selling pressures, making the appearance of fear self-fulfilling (as the market experienced in 2008).
For much of the past year, periodic bouts of worry among traders concerning tariffs or inflation have benefited the stock market, since a benign backdrop has mostly prevailed. But with the advent of fresh credit-related fears across several markets—including for auto loans, credit cards, student loans and, more recently, regional banks—the latest increase of fear is making its presence felt in concerning ways.
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The Financial Times recently ran the headline: “U.S. regional bank shares sink on credit worries after fraud disclosures.” It highlighted disclosures by Western Alliance Bank (WAL) and Zions Bancorp (ZION) that revealed both lenders were exposed to “alleged fraud by borrowers, raising broader concerns about the health of bank loan portfolios.”
This development follows closely on the heels of the loan-related problems for the subprime auto lender Tricolor, which have left credit investors with significant losses, while prompting increased scrutiny from the U.S. Department of Justice. The latest revelations also prompted a sharp sell-off in some of the market’s leading regional bank shares in what, for many of them, was their biggest one-day decline of the year.
Also reflecting the rising credit concerns is the latest share price performance for investment bank Jefferies (JEF), which has seen its stock plunge over 30% in just the last couple of weeks, its worst performance since March 2020. Accounting for the selling pressure are worries over the bank’s exposure to global automotive parts producer First Brands, which last month filed for bankruptcy.
Banking executive Jamie Dimon, in an earnings conference call for JPMorgan (JPM) earlier this week, vocalized the market’s rising concerns over the private credit market when he said, “When you see one cockroach, there are probably more.”
However, the return of fear is creating an opportunity for contrarian-minded investors as participants increasingly turn their attention toward under-the-radar, defensive assets.
Indeed, a key feature of turnaround investing involves embracing a contrarian approach. It involves searching for sectors and stocks that are currently out of favor, but which look primed to enjoy a rebound, once investors begin to see the value in these assets.
For most of the last several months, the tech sector has enjoyed most of the market’s attention, allowing semiconductors, AI and related segments to build momentum and attract even more attention from traders.
But now there are signs that a sector rotation is underway involving a turn toward more defensive-oriented assets. Among them has been one of this year’s most neglected sectors, the consumer staples. In fact, as of the end of September, the S&P consumer staples sector was the worst performing of the 11 S&P sectors, with tech and communications services leading the pack.
But in just the last few days, we’ve seen a resurgence of interest in consumer staples, with the Consumer Staples Select Sector SPDR Fund (XLP) rallying strongly. This was after I pegged the staples sector this summer as being a likely outperformer in the latter part of the year in the Cabot Turnaround Letter. At that time, XLP was trading at discounts of between 20% and 55% across standard valuation metrics compared to the S&P 500.
We already have decent exposure to the consumer staples in the portfolio, including through holdings like Dollar Tree (DLTR, one of our top performers) and other stocks. We’ve also highlighted consumer staples giant PepsiCo (PEP) in the newsletter after activist investor Elliott Management took a $4 billion stake in the company and is now pushing for major changes. (Incidentally, Pepsi represents the hedge fund’s largest ever equity position.)
Another key area of interest for us in the healthcare sector, which is finally beginning to realize the bullish potential that I’ve been calling for in recent months. I pointed out earlier this summer that recent financial market behavior in the S&P 500 Healthcare Sector SPDR ETF (XLV) suggested strong returns on a 3-month, 6-month and 1-year basis ahead, and so far, the healthcare ETF hasn’t disappointed.
To reiterate, my top two contrarian sector ideas for the fourth quarter of this year are consumer staples and healthcare, and it’s perhaps not coincidental that both happen to be two of the most defensive of all S&P sectors. That could prove prophetic if, as a growing number of analysts are predicting, the more economically sensitive areas of the market enter a period of turbulence in the coming months over ongoing inflation concerns and rising credit risk.
And finally, on the inflation score, with inflation running at an official rate of 3% and 90% of all public fixed income outstanding running at under 5%, this leaves a shrinking rate of real return for investors looking to hedge against inflation. That’s according to the latest survey by Apollo Global Management.
This is likely one explanation for the massive resurgence of interest in gold and silver—and another reason for expecting the momentum in the precious metals to persist. I believe our gold and silver stock mining company holdings will continue to benefit from this trend, and I recommend that investors own some exposure to this market segment to hedge against a potential increase in market turbulence.
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