A Plan When Good Things (Rising Equity Market) Come to End

Tailoring downside portfolio risk to an investor’s risk tolerance, goals/objectives, and future cash flows can help reduce the probability the investor will experience a catastrophic loss. 

I last wrote (way too long ago) that hope isn’t an investment strategy when the markets start moving against you, but I failed to give a solution.  A client then wisely asked me to elaborate on the plan we have in place for him, so I walked him through it.

Below is an abridged version of my response.  It outlines his, as well as other clients, portfolio risk management strategy.  Nothing is full-proof, but what this strategy does attempt to do is prevent losses from becoming catastrophic.  This is where panic selling often takes place, compounding the losses. 

By focusing on the client, their risk tolerance, goals/objectives, and future cash flow we can put together a plan that helps reduce the probability of a loss that would have drastic implications for the client moving forward: 

1. Diversification.  By utilizing bonds we can help reduce the downside if equity markets fall.  This smooths returns over the long-run and helps balance the account when stock returns get ugly.  Still, even with diversification returns can be much lower than would be expected given historic returns and volatility…
2. Quality.  We keep the bulk of our assets in Large Cap equities and also allocate more to blue chips in that space.  This minimizes exposure to some of the riskier equity asset classes out there.  So while we may have a muted upside, we believe the downside should also be muted.  Still, the baby can get thrown out with the bath water when the market tanks, so we aren’t done…
3. De-Risk.  We are still bullish on equities now, but what if that changes or we are wrong?  We look for market signals to tell us when we should de-risk the portfolio (e.g. sell equities).  These signals tell us if the market is at a greater risk of a large loss and happen as the market moves down, so we aren’t trying to pick the top, but rather avoid much of the bottom(ing).  These signals have been very good in the past, we have custom models that illustrate this, but there is a chance they could not work…
4. Custom Waterline.  We put together a bespoke cash flow model for our clients, which maps their inflows and outflows moving forward.  From this we can develop a “waterline” – the minimum portfolio value a client can have and may still reach their long-term financial goals.  What this means is that if all the above risk metrics fail we can move to cash on the equity side when this value is met.  Using the waterline allows us to manage specifically to THE CLIENT’S needs and helps increase the probability we keep them financially stable over the long-run.

Ultimately these strategies are in place to protect the downside for the client, and subsequently help give them some clarity.  If we can do that by minimizing the downside risks, the returns should take care of themselves.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

While there is no assurance that a diversified portfolio will produce better returns than an undiversified portfolio, and it does not assure against market loss, a diversified portfolio can reduce a portfolio’s volatility and potential loss.

Large cap stocks typically have at least $5 billion in outstanding market value. 

Good Things Come to End, Have a Plan

Hoping and wishing your portfolio will hold up when the market turns negative, and turn it will, isn’t a strategy.  Being prepared is the only prudent way to invest.

The last few commentaries have had a bullish bent, and rightfully so, but it’s important for me to scratch my “always concerned about the markets” itch.

Here is a snippet from legendary investor Seth Klarman’s letter.  The whole thing is great, but below are my favorite parts:

• On the current state of the economy/markets: monetary policy is distorting markets, Fed can change how things look, but not what they are, Europe isn’t any better, not many bears left, unsustainable tech business models. 
• “Someday, financial markets will again decline.”
• “Someday, professional investors will come to work and fear will have come to the markets and that fear will spread like wildfire. The news flow will be bad, and the markets will be tumbling.”
• “Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

Currently, in light of all this, Klarman returned $4b to investors and is 40% in cash.  He can’t find much to buy as everything has been bid up.  Does that mean the market is destined to collapse at any moment?  No, and Klarman noted that in his letter. 

But what he does say is that markets will decline again.  I wouldn’t bet against that assumption.  Further, he noted that most will be unprepared for such a drop and thus will be very vulnerable when this happens.

Don’t wish, don’t hope.  Have a plan to protect your capital.  That is the foundation of how I approach investing.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Recessions Matter

Despite the lack of correlation between equity markets and economic growth, de-risking before a recession can help investors avoid large losses. 

Sorry for the delay, but have been out of the country only to return and have a presentation to put together.  Luckily the presentation yielded much commentary level material.  The first of which I want to cover is why recessions matter.

Most probably view this as common sense, but the reality is often times the market and the economy don’t run in sync.  For example, the market bottomed in Q1 of 2009, but the economy was still very weak.  Recently, GDP growth for much of 2013 was lower than that of 2012, but the market basically doubled its return in 2013 from 2012. 

Anyway, by and large is that economic forecasting shouldn’t be a huge factor in determining how you allocate your portfolio.  Aside from being terribly unreliable, even when they are spot on the market may behave in an unexpected way.  I agree with that for the most part, except when it comes to recession forecasting.  Here I walk through why:

1. A reduction in corporate profits often leads or coincides with recessions.
2. As one would expect, profit growth is highly correlated with the S&P 500.  Also, that larger market declines happen when earnings fall at or around recessions:
3. Thus, it follows that if economic growth is positive, as it is projected to be, earnings should grow and subsequently the market.
4. But more importantly, if you have a beat on when the economy will slow (and that is very hard to do) you can get out in front of a fall in corporate profits and the subsequent fall in the market.

The takeaway is to use economic forecasts as part of your risk control strategy to move out of stocks before they have a large move down.  But don’t have it be your only piece and certainly don’t go risk heavy because the economic growth is expected to rip as there are other factors at work.  This is a drawn out way of saying “win by not losing big” and seeing storm clouds on the horizon can help with that.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market The Dow Jones Industrial Average is a widely watched index of 30 American stocks thought to represent the pulse of the American economy and markets. 

Not Seeing 1929 Today

While a chart comparing 1929 to now is unsettling, digging deeper reveals the risk is marginal, more subdued, and noise to disciplined investor.

A friend of mine asked my thoughts the above chart, which has been popular over the last week.  Naturally when you see our current stock market compared to 1929 that raises some alarm bells, but let me dampen some of those concerns (also see here and here):

1. Chart overlays are relatively common.  I see maybe 5 a week?  This one took off I would suspect given the 1929 comparison.  That doesn’t invalidate the chart, just shows that this isn’t the only chart overlay around. 
2. When looking at the chart, the first thing that came to mind was the scale (see below numbered bullets).  As Jeff Saut notes:  “You can ‘scale’ any chart to do just about anything you want it to imply! In this case, the scale makes the comparison to 1929 with the present stock market chart pattern appear eerie. However, if you index that same chart so that you are comparing apples to apples, the correlation to 1929 disappears.”
3. For arguments sake, let’s say this isn’t just a coincidence and that the market does follow the path implied by the chart.  The 1929 fall was about 50% per the chart, when scaling to today that fall would be almost 20%.  So while it would indicate a bear market, a properly diversified portfolio with some risk control parameters would certainly weather this storm.
4. The 1929 crash was after a near 10 year bull market.  We are 5 years into this bull market and I would guess the euphoria in 1929 dwarfs the enthusiasm for stock now.
5. The 1929 crash was also after a massive leveraging up.  We are currently deleveraging or maybe bottoming there, but certainly not in ramp up mode.
6. Totally different monetary systems.  We were pegged to Gold then and have a fiat currency now.  This means the Fed can create liquidity during market stress if they see fit, which could (and has since 2009) put a floor on the drop.

Is there anything to the chart overlay?  Probably not.  It could be coincidence or perhaps the author was looking for confirmation bias (searching for evidence to support his claim).  While I do think investor behavior tends to rhyme (not repeat), I just have a hard time seeing that in this chart.  And at least on the positive side this is a good reminder there is always risk in the markets.

Hopefully investors didn’t react emotionally to the chart as since it came out the S&P had a nice snapback and is close to flat for the year.  Nothing about the latest pullback indicates there will be a sustained fall in the markets, but if that proves to be false and the chart overlay comes to fruition a strategy to minimize drawdowns likely will prove more useful than the chart.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market The Dow Jones Industrial Average is a widely watched index of 30 American stocks thought to represent the pulse of the American economy and markets. 

Patience Can Help With Capital Preservation

“A cheap asset presents an opportunity for increased future returns, but if your goal is minimize your drawdowns, then wait for those assets to stabilize.” 

In my 2013 thesis I used the following: “On a relative value basis… emerging markets face secular headwinds they do appear cheap.”

If you read my commentary and/or listen to Warren Buffet you buy assets when they are cheap.  The price you pay is as important as the quality of the asset you are buying.  This increases the likelihood that future returns will be higher.  The logic is simple, but I do think comes with a caveat.

I noted later in that thesis the following on Emerging Markets: “while there are opportunities for upside until the trend reverses it’s hard to have much conviction”.  Trends in major asset classes start quickly, but play out over a longer time period.  As result, if your goal is to get reasonable returns over a longer time horizon and reduce your risk it makes sense to wait until the trend appears to have bottoms and more than likely has moved into an uptrend.  Thus, while you miss some of the upside, maybe even the bigger moves, you also avoid the large moves down in that asset.

Which brings me to Emerging Markets, here is what they look like as of 02/03/14 close:

What I see:

• YTD down 7%
• Trend is moving down, doesn’t appear to be stabilizing
• Valuations are now cheaper, but they were cheap to start the year (i.e. just because an asset is cheap doesn’t mean it will reverse)

Thus, while enticing on a value basis patience can help you avoid any further drawdowns before adding to this position, or any other asset class in a downtrend. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.