Buy into depressed stocks

There has been much talk about this year being uncannily similar to 2011, which was a pretty frightening 12 months. However, there are some notable differences. The resilience of high-yield debt has surprised us so much so that we question whether the current trend is sustainable. Many major equity indices have given away most of their gains for the year.

The iShares MSCI World ETF, for example, is now flat over the year, having been up by nearly 10% in mid-March. The Pimco Global High Yield Bond fund, on the other hand, has maintained a consistent uptrend, barely correcting after the turmoil of the past few weeks. The fund is still up by nearly 7% so far this year and is within 1% of this year's highs.

This divergence is in contrast to what we saw last year, when high-yield bonds closely tracked the slump in equity markets. They lost nearly 15% from their peak (compared to a 20% drop for iShares MSCI World) in the wake of the American downgrade in August and renewed fears over the future of the eurozone.

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Since we first began investing in high-yield bonds at the end of 2008 we have always viewed the asset class as a lower volatility proxy for equity exposure. Over the past few years high-yield bonds have moved pretty much in line with equities, but offered lower volatility at the same time (and, in retrospect, higher returns!).

So we saw the recent decoupling of the two asset classes as an opportunity to take some profits and reallocate part of the proceeds to equities. Earlier this week we disposed of a large part of our high-yield bond holdings to raise cash to buy into depressed equity markets.

We have been using part of the proceeds of our sales to increase our allocation to emerging-market equities. Two funds we like in particular are the iShares Emerging Markets ETF (LSE: IEEM), which has fallen by 15% from its high in mid-March of this year, and the SPDR S&P Emerging Market Dividend ETF (LSE: EMDV), which has fallen by nearly 20% from its peak in March of this year. We have also been following closely (but have not yet bought) the iShares EURO STOXX Total Market Value Large ETF (LSE: IDJV), which offers exposure to large-cap European value stocks, such as Total, Sanofi and Telefonica. It has now fallen back to the lows it reached in March 2009 and looks increasingly attractive.

Time will tell whether selling high-yield bonds to buy equities was the right choice, but our feeling is that there is a better chance of emerging-market equities ending the year with positive returns than of high-yield bonds continuing their current uptrend (which would imply an annual return of nearly 20%). As difficult and painful as it may be in the short term, we have almost always been rewarded by selling securities that have touched all-time highs.

Although we have spent substantial amounts of cash buying equities over the past few days, we have also retained significant amounts of liquidity (cash and short-dated bonds), as we are certain that there will be further turbulence in equity markets and therefore further buying opportunities in the months ahead.