As equity markets bounce off new highs, many are wondering how much further stocks can go before they pause or even correct. The temptation to time the market can be hard to resist. But history has shown how difficult it is to predict when the market will turn. Recall this past spring (and many others for that matter), when some market watchers were encouraging investors to heed the old adage “go away in May.” Those who did, however, would have missed out on significant additional upside.
Can stocks rise further from here? On the whole, valuations do not seem to be at extreme levels. Markets are forward looking, and global growth trends remain positive. However, in this politically charged environment, anything can happen. Much depends on fiscal policy implementation and how geopolitical tensions play out. And even though a more normal interest rate environment should benefit stocks, we could still see upticks in volatility in response to monetary policy implementation.
So, while we see continued upside potential in equities, our cautious optimism is balanced by our recognition that managing risk is critical in all phases of the market cycle.
I’ve been using convertible securities to manage risk and reward since the late 1970s. When I look back over the decades, I’m reminded of how effective convertible securities can be in this type of environment as a core equity holding within an asset allocation framework. In my experience, a convertible allocation managed with an eye to both capital appreciation and capital preservation can mitigate the need to make a market timing decision. This is especially important for core allocations, which should be held through full and multiple cycles. Today, investors should consider convertible strategies as a core component not only of their U.S. exposure but also as a means to capture upside in the global markets.
If managed properly, a convertible allocation can provide a good balance between upside participation and downside protection. More specifically, the equity characteristics of a convertible can give the investor a chance to participate in the continued advance of the stock market, while fixed income characteristics may provide potential downside protection in the event of equity market turbulence or even a correction.
Active management is absolutely essential for capitalizing on the unique structural benefits of convertibles. The attributes of convertible securities can change over time. As we explain in our convertible guide and asset allocation whitepaper, these changes apply both to individual convertibles and the convertible universe as a whole.
Without active management, the risk/reward attributes of a convertible strategy could fluctuate dramatically. An investor with a passively managed strategy could end up with far less equity exposure than they once had—or far more. Depending on market conditions, a passively managed strategy could leave you underexposed to equity upside or far too exposed to market downside.
Conclusion
Convertible securities can be an excellent choice for a strategic allocation. But achieving—and maintaining—the appropriate risk/reward characteristics requires active management. After all, if you’re taking a convertible out for a drive, you should be sure that the button to put the top up works when you need it to.