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  • Stocks have rallied sharply since June.
  • Investment banking stocks are entering resistance, and demand remains weak.
  • Telecom stocks offer attractive yields, reasonable valuation, and relative strength during a recession.

Everyone is debating whether the recent stock market rally is a bear market head fake or the beginning of a sustainable bull market advance. Undeniably, the past six weeks have seen an eye-popping rally. The S&P 500 is up 13.6% since June 20th, and individual industries have performed better. For instance, the iShares Broker Dealer ETF  (IAI)  is up 17% since its mid-June low. Yet, economic headwinds remain challenging as long as the Fed’s increasing rates, and as a result, analysts are increasingly pessimistic about earnings for the rest of the year.

The persistent risk of recession, and the resulting damage it can inflict on corporate earnings, casts a shadow over stocks' recent strength. So while stocks may continue gaining ground, it could be prudent to trim exposure to stocks that have run up into resistance and then use that money to buy defensive stocks inelastic to recession.

A stock to trim

The poor stock market performance and rising interest rates have put the kibosh on initial public offerings (IPOs) and corporate debt offerings this year, creating a headwind to investment banks.

High yield bond issuance is down 78% year-over-year through the first half of 2022, and additional weakness has volume on pace to be the lowest since 2008. According to Fitch, investment-grade issuance is a bit better, but it’s still down 26% year-over-year through June.

The IPO market is similarly weak. Fueled by the launch of Special Purpose Acquisition Companies, or SPACs, the IPO market provided plenty of revenue opportunities for investment banks. However, regulatory concerns and many recent SPACs' poor performance have kept a lid on issuance this year. For example, 589 SPACs were IPO’d last year. There have been only 27 this year, according to Factset. The weak appetite for SPACs, plus less attractive IPO valuations, means there were 54% fewer IPOs in Q2 worldwide than in the same quarter last year.

Likely, the IPO market will rebound during the next bull market, and debt issuance will pick up once rates stabilize or start falling. But, until then, revenue and profit at banks with a lot of exposure to investment banking could remain under pressure.

In “Here's Why We're Acting Now to Make These 2 Trades,” Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace explain why that risk is one reason they’re reducing their weight in Morgan Stanley  (MS) , one of the biggest investment banks.

They write:

“We are taking advantage of the outperformance in MS shares, which have climbed almost 20% since mid-June, handily beating the S&P 500 over the same period, to modestly ring the register…The catalyst for the trade in Morgan Stanly shares is that outperformance has put them almost at the top of their trading range, near the 200-day moving average. In short, there is resistance ahead, and with the IPO market remaining cool as well as year-over-year comparisons for the M&A market slowing, we'd rather act now than miss the opportunity.”

As you can see in the following chart, Morgan Stanley has rallied substantially since mid-June, and shares are now entering key levels where sellers may emerge. Typically, it requires greater “energy” to push up through resistance than at the lows because trapped sellers are eager to sell to “get out flat.”

CHART_080922

Since Morgan Stanley is a top 10 holding in AAP’s portfolio, taking a little off the table after its big move makes sense. After the sale, Morgan Stanley’s accounts for 3% of AAPs portfolio, down from 3.3% previously.

A stock to buy

Lang and Versace are using the proceeds to buy more shares of Verizon  (VZ) , the telecommunications giant. Historically, telecom companies provide defensive market exposure because, like utilities, demand for phone service is relatively inelastic to economic drops.

CHART-Business-Cycle-0506

AAP initiated a ‘starter position’ in Verizon in June. At the time, Lang and Versace wrote, “We see modest downside in the shares from both a fundamental and technical perspective while EPS expectations for the coming quarters have yet to be lifted for previously announced wireless price hikes, some of which begin to phase in as soon as today. We are beginning with a starter position in VZ shares, and we would look to build out that position size at better prices should they present themselves.”

They made good on their promise to buy more shares in July, and they’re bulking up their position further this week. After their latest purchase, Verizon represents 2% of AAP’s portfolio, suggesting they have room to increase exposure further.

Since Verizon pays a $0.64 quarterly dividend, it’s yielding a healthy 5.7%, so buying more shares helps the portfolio's income stream. Importantly, its dividend appears safe. Although wireless customer additions slowed last quarter, it still expects full-year revenue growth of 9% and full-year adjusted EPS of $5.10 to $5.25.

The Smart Play

Just as it can make sense to prune the plants in your garden, pruning stocks in your portfolio can be smart, too, especially if your catalyst for owning them is under pressure.

Investors who own Morgan Stanley shares because of its investment banking business may want to pare back or normalize the weighting in their portfolio since shares are in resistance. Remember, you can always repurchase shares when there’s a better risk to reward, investment banking prospects improve, or if shares sell off again.

Slowing consumer wireless growth could be a headwind for Verizon, but historically, telecom stocks have outperformed during a recession. Moreover, Verizon’s valuation is attractive. It’s trading at the low end of its five-year P/E range of eight to 14. If it trades back to the midpoint of its range, it will gain 27%.

If you follow in AAP’s footsteps, consider buying Verizon in tranches. Spreading out your buys provides you with some margin of safety and a chance to improve your average cost if shares fall.

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