Why you should stick with US large caps and high yield

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Within the United States, I recognize opportunities, particularly in large cap, cyclical names. On the fixed income side, high yield now represents an attractive option given recent spread widening.

To be sure, the relative value offered varies segment by segment, and you can read more on my specific country and segment outlooks in my latest Investment Directions monthly market outlook.

Looking forward, financial markets remain vulnerable, particularly if we see a further tightening of monetary conditions because of a stronger U.S. dollar. For now, however, I view the recent volatility upsurge as an indication of markets returning to normal after several years of investor complacency and uncommonly low volatility.

large cap equities

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Market Realist – Large-cap stocks usually hold their value better in the case of a sell-off like what happened over the past couple of weeks. The graph above shows the total year-to-date returns from the S&P 500, which tracks large cap equities (SPY), the S&P 400, which tracks mid-cap equities (MDY), and the S&P 600, which tracks small-cap equities (IWM). Large-cap equities have been able to hold their value better than small-cap and mid-cap stocks.

As the economy continues to improve, cyclical stocks are likely to benefit more than other segments. Technology stocks (XLK) could be a good investment opportunity in this scenario. From a relative valuation point of view, it would be better to avoid “new tech” companies, including social media giants like Twitter (TWTR) and Facebook (FB). They seem considerably overvalued compared to the “old tech” sector, which includes system and hardware companies. As the economy continues to strengthen and the age of capital stock continues to increase, you can safely expect an increase in companies’ capital spending. This can help technology companies in the future.

Markets have seen a period of relative calm for the past couple of years, but the honeymoon period seems to be over. The recent volatility surge is likely to continue as the Fed initiates its policy of rate normalization. As the markets remain volatile (VXX), investors would do best to increase the diversification in their portfolios in order to maximize their risk-adjusted returns.

Read our series Protecting your portfolio: 4 key defensive strategies to learn more about how you can protect your portfolio.

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