Goldman Sachs has updated its winning strategy for raking in huge returns when markets are going haywire

Caetano Barreira/Reuters

• Goldman Sachs' equity strategists anticipate that a trade war and higher interest rates would increase volatility in the stock market.
• They recently updated their High Sharpe Ratio basket, which includes stocks that are likeliest to produce the best risk-adjusted returns.
• The basket has outperformed in periods when volatility is above-average, said David Kostin, Goldman's chief equity strategist.

As the trade fight between the US and its major trading partners keeps ratcheting up, Goldman Sachs' equity strategists want clients to be prepared.

In the latest blow, China announced tariffs on $50 billion worth of American imports in response to similar US taxes. These trade tensions are rocking the stock market more vigorously than in 2017, as measured by the CBOE Volatility Index.

On Monday, the Dow Jones industrial average fell by more than 300 points, or 1.2%, and approached a correction for the second time this year.

"Escalating trade tensions and further monetary policy normalization could result in realized volatility remaining meaningfully above last year's 6.7 through the end of 2018,"David Kostin, Goldman's chief US equity strategist, said in a note on Friday.

He added: "This raises a key question for investors: which sectors and stocks are likely to produce the highest risk-adjusted returns in a market with below-average returns and elevated volatility?"

The answer to this question lies in stocks with a high Sharpe ratio, Kostin said. The ratio, developed by the economist William Sharpe in the 1960s, helps investors identify stocks with the best risk-adjusted returns.

Goldman's High Sharpe Ratio basket includes stocks that have the highest ratios in every S&P 500 sector, which should deliver the best risk-adjusted returns even with higher volatility. It factors in consensus forecasts and the volatility implied by options prices. Kostin said the basket of stocks has underperformed the S&P 500 year-to-date by 2 percentage points, but has generated an average six-month excess return of 334 basis points since 1999.

"The basket performs best alongside above-average volatility, generating an average excess return of 559 bp in periods with realized volatility greater than 15 vs. 120 bp when realized volatility measures less than 15," Kostin said.

A recent iteration of the basket included stocks that outperformed the market when absolute and relative volatility were low, like in 2017. But with volatility rising, Goldman has added nearly 40 new stocks to the basket, which are concentrated in the biotech, semiconductors, tech hardware, capital goods, food beverage, and tobacco industries.

Some of the new stocks are:

• Consumer discretionary: BorgWarner
• Healthcare: Celgene
• Industrials: Delta Air Lines, Honeywell
• Consumer staples: Coca-Cola
• Telecommunication Services: AT&T
• Energy: Halliburton
• Financials: Prudential Financial
• Information Technology: Oracle
• Materials: Albermarle Corp.
• Utilities: Edison Intl.
• Real Estate: Equinix Inc.