A fund manager at a $629 billion firm lays out his strategy for 'making money at the expense of machines' during the stock market's sell-off — and shares 4 sectors he's betting on

  • Steven Chiavarone, co-manager of the $395.3 million Federated Hermes Global Allocation fund, says investors should stay put and not panic just because of Thursday’s market sell-off.

  • The investor is looking for opportunities in the technology, consumer, industrial, and biotech sectors as the economy continues on the path of recovery.
  • He also explains why the fund’s portfolio management team places their highest conviction bet on small-caps as the economic recovery takes hold.
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On a day when the S&P 500 index fell 3.5%, the Dow Jones Industrial Average shed over 800 points, and the tech-heavy Nasdaq plunged almost 5%, Steven Chiavarone thought investors should not panic but stay put. 

"There's no apparent catalyst in terms of poor economic data releases or negative news flow, so my best guess here is that you've had a couple of technical indicators that triggered," said Chiavarone, who is a co-portfolio manager on the $395.3 million Federated Hermes Global Allocation fund. The firm manages $629 billion in assets. 

Highly valued tech stocks dragged the stock market lower Thursday, setting off the worst single-day loss for US stocks since June. 

The S&P 500's relative strength index, which is a momentum indicator that measures the speed and change of price movements, hit 80 on Thursday. Meanwhile, the large-cap index was trading 15% above its 200-day moving average for the first time since January 2018. 

"Eighty is a pretty extreme reading, there are not too many times it gets that high," Chiavarone told Business Insider on Thursday. "A lot of algorithms out there are built to look for certain technical indicators and levels, and when they're triggered, it sells. That probably happened today."

However, if a meaningful pullback happens, Chiavarone said he has "absolutely no qualms about making money at the expense of the machines that don't understand the whole picture."

The manager, who co-runs the multi-asset fund with five other investors, adopts a top-down macro approach when it comes to taking sector bets and selecting securities. 

"We think the overarching theme in the marketplace right now is an economy that has exited recession and is entering recovery. That is first and foremost a good environment for stocks," he said, adding that stocks are providing capital protection and are more attractive compared to the 10-year Treasury notes, which have been yielding 50 to 60 basis points. 

Within the universe of US stocks, Chiavarone and his team are betting on sectors that are poised to do well coming out of a recession. 

"Those sectors that do best are tied towards economic growth," he said, noting that technology, consumer staples, industrials, and biotech are the four sectors that stand to benefit as the economy heals from the COVID-19 crisis. 

"You're going to continue to see a recovery in the consumer, particularly as we continue to add jobs," he said. So we like consumer sectors. I think you're going to see a stockpiling of medical equipment and medication in response to the pandemic so areas of biotech and pharma are attractive."

Small caps as a recovery play

As the market rally broadens, Chiavarone said the team's highest conviction lies in small-cap stocks, which he defines as those included in the Russell 2000 index. 

Small-caps are most likely to outperform on the way up because small companies are more tied to the underlying growth of the economy compared to large- and mega-cap companies.

"Just as smaller companies, in general, were most impaired from the cyclical downturn in the economy, they will also, therefore, benefit the most from a cyclical rebound," he said. 

Small caps could also make the most out of a low-interest-rate environment because 50% of small-cap company debt is bank debt, which oftentimes comes with variable rates. Whereas for companies in the S&P 500, most of their debt structure is fixed-rate and only 10% is bank debt, according to Chiavarone. 

"The likelihood that those rates are going to stay low for an extended period of time given the Fed's dovish pivot towards average inflation targeting tells us the debt expense of small-cap companies is a tailwind today and is likely to remain a tailwind for some time," he said. 

For investors who are unconvinced, small-caps historically tend to outperform large-caps by about 25% in the first year following a recession bottom, and the "digital industrial revolution" will only lead the market to aggressively seek out and reward smaller companies that seek to disrupt the status quo, he said.

Some of the small-cap stocks in the Federated Hermes Global Allocation fund include Achillion Pharmaceuticals, Inc. (ACHN), Systemax Inc. (SYX), and Photronics (PLAB), according to its portfolio fact sheet. 

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