A top Wall Street strategist reveals a game plan that earned 10% as stocks plummeted last year - and how investors can profit from it now

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A top Wall Street strategist reveals a game plan that earned 10% as stocks plummeted last year - and how investors can profit from it now

Binky Chadha

Bloomberg

Binky Chadha

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  • Investors had few places to find shelter from the storms that wrecked the stock and bond markets in 2018.
  • Binky Chadha, Deutsche Bank's chief global strategist, has highlighted a strategy that gained 10% last year - one that he expects to outperform again this year.

2018 was a tough year for many investors.

US stocks suffered their first annual decline since the financial crisis and the safety net of bonds failed investors. In contrast, those with the savvy to load up on cash and its equivalent instruments boasted decent returns.

But moving to cash wasn't the only way to make money last year. Binky Chadha, the chief global strategist at Deutsche Bank, is spotlighting one such strategy that earned a plump 10% return while the broader stock market wallowed. In 2017, it gained 12%.

It's part of a four-part approach that the firm formulated for each stage of The business cycle: early cycle, mid cycle, late cycle (where we are now), and end cycle. Every stage consists of handpicked long-short baskets of stocks.

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The graphic below shows that the strategies have historically worked as advertised. On an annualized basis since 1982, the long-short baskets have posted the strongest returns during the corresponding phases of the cycle. In other words, the late-cycle basket has been best-performing in the latter phase of the cycle, and so on.

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Deutsche Bank

"In our base case that the cycle still has legs, we see the late-cycle basket continuing to outperform," Chadha said in a recent note to clients.

Read more: We interviewed Wall Street's 8 top-performing investors to get their secrets for success - and their best ideas for 2019

Chadha specifically defines 'late-cycle' as the era in which economic growth is still robust, but the labor market has tightened and the official unemployment rate is below its natural rate. Recent trends in the job market affirm his late-cycle characterization, as does the simple fact that the economic expansion will become the longest in history this year.

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And yet, Chadha doesn't see the next downturn as imminent. Sure, the length of the cycle and the degree of slack in the labor market both flash a late-cycle signal. But in his view, other indicators like wage growth, loan delinquencies, and capital spending indicate that this expansion has more room to run.

This implies that for now, investors are stuck on recession watch, balancing the risk of exiting the market too quickly with the pain of holding on for too long into the bear market.

This waiting game is one that Deutsche's late-cycle strategy is positioned to profit from. According to Chadha, the strategy focuses on high-quality companies and bets on stocks with high free-cash flow, low net debt, and low debt growth while shorting those with high net debt and debt growth.

In the long basket of stocks, Deutsche's buy-rated picks include Expedia, Nordstrom, Advance Auto Parts, and Ralph Lauren.

Chadha's advise to focus on quality stocks rhymes with the recommendations offered by his counterparts at other firms.

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Savita Subramanian, the head of US equity and quant strategy at Bank of America Merrill Lynch, said in a client note that quality companies with stable earnings outperformed in 2018. Buying such stocks is a strategy that should continue to work in 2019, she said.

Similarly, David Kostin, the chief US equity strategist at Goldman Sachs, advised clients to increase portfolio defensiveness by buying quality companies with strong balance sheets. He said these companies are positioned to outperform even in periods of economic uncertainty.

By all indications, Wall Street is in such a period, with US economic and profit growth expected to slow this year and talks of a 2019 or 2020 recession getting louder.

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