The 10Y/2Y Treasury yield spread has a long history of forecasting U.S. recessions by about 18 months; that means we are officially on recession watch, observes David Dierking, fund expert and editor of TheStreet' ETF Focus.
So what does this mean for your portfolio and what should you do right now? Your first inclination might be to sell stocks and move into bonds, cash or some other defensive asset, such as gold.
History shows that might not be such a good idea for now at least. In the five most recent yield curve inversions, the S&P 500 was up more than 10% a year later in four of those instances. It’s almost as if investors know what’s coming, but they still want to squeeze every last drop of blood out of the turnip.
I suspect the first thing we’re going to see from the market is a rally in long-term Treasuries. While short-term rates are still moving higher based on what it expects the Fed to do, long-term rates have flattened.
That’s a result of investors believing that the Fed will begin cutting rates again in the intermediate-term. That’s also consistent with the idea that a recession could officially arrive within 18 months, if not sooner.
There’s a lot that can happen between now and then that would change these expectations (and usually does). Plus, the Fed is notoriously difficult to predict. I do, however, think the general direction of this forecast is correct and probably should be expected at this point.
The question now is how do you protect your portfolio from what is coming? There are any number of ETFs out there that can offer protection in some form or fashion.
Some just shift to defensive stocks or bonds. Others own puts on the market outright to profit when stocks decline. Here are five ETFs for investors to consider if you’re looking to limit downside risk.
Innovator Laddered Allocation Power Buffer ETF (BUFF)
I’m a big fan of this fund and “buffered” ETFs in general have seen big asset inflows over the past few years. Innovator’s buffer ETFs invest in FLEX options on the major indices that provide protection against a pre-determined level of losses in exchange for a cap on upside potential.
The “Power Buffer” ETF provides protection against the first 15% of losses over the outcome period, but caps index gains at around 9% (it fluctuates depending on market conditions). BUFF holds on equal allocation to 12 monthly buffer ETFs that reset every month.
This is a great way to protect your portfolio while maintaining the ability to capture the upside in stocks in case you’re wrong. Innovator offers Buffer, Power Buffer and Ultra Buffer ETFs that provide different levels of protection and caps.
Cambria Tail Risk ETF (TAIL)
TAIL is a pure downside hedge. It buys put contracts on the S&P 500 that become more valuable as the index falls in value. It also holds most of its assets in a combination of Treasuries, TIPS and cash.
While the fund will lose money more often than not (because the S&P 500 rises more often than not), it can really pay off when it’s needed the most. During the COVID recession when the S&P 500 fell more than 30%, TAIL gained more than 30%.
Global X Adaptive U.S. Risk Management ETF (ONOF)
ONOF utilizes a risk-on/risk-off strategy that invests in the S&P 500 when conditions look more favorable, but rotates into short-term Treasuries when conditions look bad.
The methodology for this fund is a little more complicated than what you find in the typical ETF. The idea is that it looks at various technical indicators — volatility, MACD, moving average and drawdown - to make an allocation decision.
KraneShares Quadratic Deflation ETF (BNDD)
All attention is focused on inflation right now, but recession cycles tend to come with greater deflation risk. As the economy slows or prices rise, demand for goods and services declines and prices end up coming back down.
BNDD is a fixed income ETF that seeks to benefit from lower growth, deflation, lower or negative long-term interest rates, and/or a reduction in the spread between shorter and longer term interest rates by investing in US Treasuries and options.
During its brief life since its inception just over 6 months ago, BNDD has essentially matched the performance of the S&P 500 with a fraction of the risk.
Nationwide Nasdaq 100 Risk Managed Income ETF (NUSI)
If you’ve followed my work, you’ll know that I’ve brought up NUSI several times because I’m a fan of it. This fund starts with an investment in the Nasdaq 100. On top of that it adds written call options to boost yield and purchased puts to provide downside protection.
What you effectively end up with is a collar on the Nasdaq 100 that caps upside while limiting downside. It also offers a juicy 8% yield right now, which is terrific news for income seekers.