Go Beyond The Usual. Are you hedged yet?
At a time where many investors are in sudden panic mode, investors who have developed an all-weather approach to investing are weathering the storm. Since history tells us that bear markets, like bull markets, tend to be much deeper and longer than most expect, it is not too late to learn and implement some approaches that will help keep your emotions in check, and your retirement plans intact.
I have invested through bear markets since the 1980s. I worked in the World Trade Center during the 1987 Crash, and navigated through the Dot-Com Bubble and Financial Crisis. During those 30+ years, I’ve realized that some things about investing remain consistent.
Trees don’t grow to the sky
One of them is that “trees don’t grow to the sky.” Markets that get extended are vulnerable to a shock. In other words, if it wasn’t a global health crisis, it would have been something else soon enough. Think of it this way: if you drink 20 beers and you feel fine, but you drink another and you can’t get up off the floor, you can’t blame that 21st beer.
The market and investors in general, like that proverbial beer drinker, set themselves up for a sharp decline in prices. Debt and deficits have been ignored around the world, stock valuations reached unsustainable levels and speculation had reached bear-market inducing levels.
So, to help you gather your thoughts during our collective international “staycation,” here is what I have learned from 30+ years of bull and bear market cycles, and what is front-of-mind for me as we enter the next phase of…whatever the next phase brings.
Bear markets exist. Get used to them.
Learn to defend and exploit them. Just because we have not had one in a while, it doesn’t mean that when we get one it will come and go. As the band Train sings, “this is not a drive by” bear market. The stock market was on the front lines the past month. However, the bond market and economy will have their turn in the spotlight soon enough.
Sometimes, “risk” happens fast. Be prepared for that.
This is why taking an ongoing, serious look at your tolerance for volatility is so essential. Do you only check your blood pressure once every few years? I hope not. Same goes for your willingness to accept the volatility and potential long periods of flat or negative returns that come with not being a hedged investor.
Diversification fails, just when you need it most
The stock market goes up more than it goes down. But when it goes down, it takes no prisoners, so to speak. Trying to find great stocks at the start of bear markets is a crapshoot.
For the time being, all stocks will generally be treated the same way as the rest. That’s how you get a 10% down day in the Dow last Thursday, and a nearly 10% up day the following day. Here is one of many charts I could show you that say the same thing: in bear markets, most equity asset classes are treated identically. Thank algorithmic trading for that.
Long-term success has a lot more to do with keeping the vast majority of what your portfolio was worth at its peak.
Beating bear markets starts and ends with an attitude. Not just any attitude; specifically, one that ALWAYS accounts for and seeks to avoid “big loss.” For each investor, “big” is defined differently.
The stock market is not the only area of your portfolio that is vulnerable these days
Sure, stocks have grabbed all the financial headlines during this 4-week selloff. And that will continue. But going forward, I think several corners of the bond market contain massive risks that most investors and pundits are underestimating.
The good news: you can hedge or exploit most risk areas in your portfolio.
Just as you can use some of the standard hedging tools (options, single-Inverse ETFs, tactical management) to hedge and exploit equity market declines, so too can you attack bond bear markets in this way. Look no further than the recent panic-buying in Treasuries and panic-selling in High Yield bonds, and I think you will see what I see: potential opportunity.
3 things to keep front-of-mind in the weeks and months ahead
All financial advice is personal. Ignore alleged universal rules. You are not part of a herd of cattle. Tightly managing risk, and seeking to profit during bear markets is not for everyone. It shouldn’t be. If you have 30 years until you retire, and you have accumulated a small portion of your eventual retirement nest-egg, hedging is a much lower priority.
Market cycles are not as convenient as we’d like them to be. Just as the longest bull market in history went deep into “extra innings,” it is not likely that this will be a blip on the radar. If you operate with that mindset, you are a big step ahead of the curve. Bear markets are no time for bravado, or lazy thinking. Get ideas like “it will eventually come back” out of your mind. It is counterproductive thinking if you are within 10 years of retirement.
The chart above shows why. On the far right, you see that the 20-year annualized return of the S&P 500 has now fallen to 3.42%. Surprised? That’s what bear markets do. And, while you can also see that this is now most of the way toward hitting historic lows last seen in the 1980s (the 20-year return ending in the early 1980s was tarnished by the recessions of the late 1960s and 1970s), it shows just how much long-term damage bear markets can do.
So, don’t spend your time blowing off the potential for this one to get much worse. If it doesn’t, we are all better off. If it does, you are much worse off for being complacent, overconfident, or worst of all, uninformed.
Investing is about setting and adjusting your portfolio’s tradeoff between seeking reward and preventing major loss in value. Too many investors severely limit themselves to a classic stock-bond world. Portfolios that simply aim to profit from long-term appreciation of the stock market, and use bonds as a “diversifier” or “rebalancer” are living in the past.
Here’s my evidence. Treasury rates have crashed. That has pushed bond returns up, masking the fact that bond returns in the future will be either negative or very, very low. If your money is managed professionally, the return on your buy-and-hold bond portfolio will likely be below the fee you pay to have that money “managed.”
The bottom 2 panels here show that recently (far right of chart), lower-quality bonds (BBB and BB-rated) have experienced sharp rises in their “yield spreads” to Treasuries. Translation: the bond market knows that it’s game-over for yield-reachers, who have diversified successfully from stock by using corporate and high-yield bonds.
Built to last…or living in the past?
Thus, the traditional stock-bond asset allocation mantra, while not extinct, will need some serious rethinking, and some additional tools. Otherwise, your portfolio will be living in the past, not built to last.
Learn to hedge.
Learn tactical management.
Learn how to transition your portfolio from bull to bear and eventually back to bull. Stay humble as an investor throughout the process.
I’m just getting warmed up (quoting Pacino in “Scent of a Woman”)
As the title says, this was a crash course. This week will likely be as thought-provoking and mind-bending as the last few for investors. So, I plan to be quite active in this space, providing some more pointed commentary on some of the key areas I noted here. To quote another famous actor, Shrek, “I’m here all week, try the veal.”