A Greek strategy

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Investors around the world are hungry today for news from a summit of European leaders in Brussels deciding the financial fate of Greece and its debt-burdened economy.

Markets have gyrated during the last few days on speculation of whether or not the European Union will provide a bailout, with some institutional investors warning of dire consequences if the leaders fail to backstop the Greek government.

The sovereign debt crisis has engulfed not only Greece, but also Spain, Portugal, Ireland and parts of the Middle East, causing investors around the world to flee risky assets. At the same time, credit default swaps used to hedge investor positions in sovereign debt have surged to record levels recently, raising concern about a new round of hidden exposure to derivatives.

In this charged environment, the EU summit adds significant risk to market conditions, says Myles Zyblock, the chief institutional strategist and director of capital markets research at RBC Dominion Securities Inc.

"A spirited equity rally could follow any hint of a resolution, while another leg down seems likely absent concrete progress to tackle the region's fiscal problems," he wrote in a report published yesterday.

It's hard for an individual investor to hedge against this two-path scenario, so instead he suggests managing the risk using "a sector barbell" that tilts the weights to one end or the other.

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Mr. Zyblock thinks that "the market is beginning to side with a more positive outcome" from the EU discussions. Germany and France were leading talks late yesterday to try to hammer out a plan in advance of the summit that would shrink Greece's deficit, estimated to be nearly 13 per cent of gross domestic product. The bond market suggested a resolution was near, with the yield on the Greek 10-year bond declining 0.37 percentage points to 6.01 per cent. But even as discussions progressed, Greek civil servants walked off the job for 24 hours in a show of force against any government move to cut debt by reducing salaries.

A resolution to the crisis should bode well for the technology and materials sectors, both of which have been hit unduly hard in the recent market selloff, and both of which are sensitive to currency swings and would benefit from a stronger euro, Mr. Zyblock said.

Technology companies generally are showing strong balance sheets, low earnings-based valuations and are seeing improving markets for their products and services, he added.

In the event that EU leaders cannot reach an agreement on how to handle the sovereign debt crisis, conditions will likely undermine confidence in the global recovery and batter stock markets. In such a case, Mr. Zyblock recommends taking shelter in the health care or consumer staples sectors. Stocks in these two categories generally provide better-than-average stability and outperform during periods of unrest, he said.

He has compiled a list of 10 Canadian issues and 10 U.S. stocks to consider in the event of an "extended market downturn" of 10 per cent or greater. Central to his selections is a 30-year pattern during downturns in which stocks showing strong predictability and momentum do well in Canada and stocks boasting predictability and growth do well in the U.S.

In all of the 13 market corrections during the past three decades, the U.S. stocks that RBC ranked as having the greatest predictability outperformed the rest of the market. U.S. growth stocks were a "distant second" in this ranking.

In addition to seven health-related companies, Mr. Zyblock's top ten U.S. list includes Kellogg Co., International Business Machines Corp. and the logistics company CH Robinson Worldwide Inc.

In Canada, the stocks that RBC rated as having the greatest predictability have performed the best in market downturns. Stocks defined as having solid momentum turned in the second best performance. The Canadian top ten list includes three financials, three consumer staples, two media, one energy and one telecom.

The 20 stocks listed offer a defensive position in a worst-case scenario. But Mr. Zyblock says he believes the market is actually poised for further gains, and in this environment RBC favours overweighting in the materials, energy and industrials sectors in Canada and underweighting in telecom, consumer staples, health care and utilities.

In the U.S. market, RBC favours overweighting in industrials, consumer discretionary and information technology, while underweighting in consumer staples, utilities and telecom.

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