When opening your next set of statements, consider August as a Portfolio Stress Test. Ask yourself, “How is it going to feel if August were to repeat itself 3 times in a row?” Are you going to feel regret as you wish you could get a second chance to reduce the risk of your portfolio?
It has always amazed me how few people, and worse, how few advisors stress test their portfolios during the “good times”. It’s doubly confusing to me why both investors and advisors are so reluctant to reduce risk when times are good. After all, isn’t successful investing about buying low and selling high? Why the reluctance to sell high?
It's a little-known but startling fact: The average buy-and-hold stock market investor spends 74% of his or her time recovering from cyclical downturns in the market (from 1900 - May 2015), according to Ned Davis Research.
Nearly 75% of investable assets in the U.S. will be in the hands of pre-retirees and retirees by 2020 (research from Blackrock). That is a lot of money that lacks the time needed to overcome a large decline.
Just hang on? That works well when you have a 30-year investment runway. It doesn't work for the aging baby boomer with a portfolio needing to generate a monthly income.
We have borrowed from the future and that future is today.
The fact is that the U.S. bull market has run practically unabated for nearly six years. The market is over-valued, aged and due for a major correction. A decline of 10% is easy to overcome. A decline of 20% requires a 25% recovery to get back to even. It is the 40% to 50% declines that keep you from reaching your goals. Overcoming -50% takes a subsequent 100% gain.
Such drastic declines tend to happen in recessions so it is that which we must defend our portfolios against.
Ultimately, success in investing is not measured by how much you gain in a bull market but how much you avoid losing when the tide turns.
Some of the Wall Street pundits say "buy the dips" - stocks that looked attractive a couple of weeks ago look like bargains now. The fact is that valuations remain far from attractive. Some say "do nothing," which is the last thing an investor wants to hear as an apparent train wreck approaches. The fundamental evidence (valuations, growth, profit margins) and now the technical market evidence both look weak.
Our view from a technical perspective is that the recent jolt to the equity markets is the first shock and increases the probability that we are in the beginning of a new cyclical bear market.
Fundamentally, we are likely in a global recession. The global sovereign debt crisis is getting worse and will further depreciate global economies. Deflation is winning. Unmanageable debt is becoming obvious to most. Greece and Puerto Rico are front page today but following them will be some bigger names: Spain, Portugal, France and others.
The point is that we should be more aggressive when the cyclical trend is bullish and less aggressive when the cyclical trend is bearish. Buy the dips becomes sell the rallies to create dry powder for future buying when prices and valuations are more attractive to your time frame.
We believe that we are seeing the beginning stages of a bear market in the U.S. This is a good time to get reacquainted with the merciless mathematics of loss mentioned above.
So, all these accusations beg the question - what do we do? I can tell you what we've been doing. Since January we have been recommending investor’s hedge or reduce their equity risk. Throughout the year we have been teaching in our “Lunch and Learn” events how to identify when the market has broken down (here’s a hint, August 2015 was the breakdown) and how to reduce risk once the market has broken.
If you have been fully invested we believe we are now in a "sell the rallies" environment. We are tactically managing our fixed income exposure and we have a large weighting to alternatives (defined as anything other than not traditional buy-and-hold). We favor tactical strategies that have the ability to get defensive. From our perspective, liquid strategies are best.
Further, we believe there is something beautiful that happens when you combine a number of low correlating risks together within a portfolio. We believe portfolios can be built to achieve a desired return relative to an acceptable level of risk.
We favor a rules based investment process that determines how much money to allocate to equities, fixed income and alternatives. If equities are hedged and a large market decline happens, the opportunity to invest is much better as forward returns will be higher.
Ironically, there is much less risk investing in equities after corrections. 30% equities (hedged), 30% fixed income (tactically managed) and 40% alternatives may then be switched to 60% equities (un-hedged), 20% fixed income and 20% alternatives.
Ultimately, it is about developing a game plan and sticking to a process. Have a plan that acknowledges the realities of our financial system - bear markets and recessions happen. They are built into the system. What goes up will come down. This market has been going up for a long stretch. When it drops, it can be precipitous and can wipe out most of your gains. Depending on where you are in your life cycle, that can be catastrophic. Many people don't have 15+ years to recover from the kind of market wipeout we experienced in 2000 and again in 2008.
It’s important to remember that while you can’t turn the clock back to reduce your risk after a decline, you can chose to increase your risk if you find that markets are moving higher after you have become more conservative. There is an old saying which rings true – “I would rather be out of the market wishing I was in than be in the market wishing I was out.”
Risk is high. For equity exposure, our recommendation is to hedge or raise cash when markets bounce higher. I can’t emphasize the timeliness of this enough. Technically markets appear to be at an important inflection point and the next 3 weeks will tell us whether August 2015 marked the end of the bull market that started in 2009.