Some two years after the last real bout of stock market volatility, we’re back in a market that seems to be heading down. Should you make adjustments to your portfolio today? If your investment horizon is anywhere above 3 years, I think you should not. But you may want to rebalance your portfolio nevertheless to prepare for what could be coming.
The Post GFC rally is facing a hiccup
Global markets seem to be stalling in early 2018. That doesn’t mean that the seemingly never ending rally that started after the Global Financial Crisis is necessarily coming to an end, but it does mean we are now several percent down for the year in many global markets:
- The S&P500 is down -3.2% YTD, though still up +10.4% over a year period
- The Japanese Nikkei 500 is down -5.4% YTD in local currency terms, though still up +16.6% over the last year
A stock market correction is defined as a -10% loss from peak to through, while a bear market is a -20% fall. Since the highest point late January (when markets rallied), we are now down -9.9% which means that we can (nearly) officially start calling this a correction. The question is whether we are going to sink further than this and if you should do anything? And what is really driving the negativity on global markets?
Geopolitical worries are the main culprit
While the markets were being boosted on what was alternatively being labeled the “Trump trade” or the “reflation trade” since late 2016, worries have now set in about a wide range of geopolitical risk factors which could potentially have destabilising economic ramifications. Investors are waking up to that.
Firstly there’s the rapprochement with North Korea, which given the two key actors involved – Donald Trump and Kim Jong Un – could make for an interesting spectacle and backfire in an enormous way.
The question is whether we are going to sink further than this?
Then there is the increasing replacement of moderates with hardliners in the US Administration. Figures like John Bolton and Mike Pompeo are nearly certain to start agitating for an increasingly aggressive stance on especially Iran and North Korea, but maybe even China. War may be on the horizon.
There is the threat of a trade war with China now that Trump has started slapping levies on them, giving Xi Jinping ample opportunity to ramp up the nationalism at home. Him becoming Chairman of the PRC for life and setting his sights on Taiwan may pose its own set of problems.
So yes, in the geopolitical sense there is plenty to be worried about. This negative sentiment is what is driving headlines at the moment. And then there’s of course also the business cycle and worries about inflation and interest rates as well as the balance sheet unwinding (removal of QE) which could hurt stocks. On top of that, Facebook is dealing with a data leak scandal.
Where we are in the business cycle adds to the worries
Currently, we are probably in the late expansionary phase of the business cycle, featuring buoyant stock markets and rising interest rates. That also means that everyone is on the lookout for the turning point and the first signs of a recession, but that nobody quite knows when it will appear. For now all the economic indicators including everything from GDP to the labor market, inflation and company earnings point to a goldilocks economy, but at some point it has to come crashing down as it always does.
Taking a step back to the last crisis, we see that stocks peaked in October 2017, and found a bottom in March 2009. Meanwhile GDP growth peaked a year later, in Q4 of 2008, while bottoming out in the second quarter of 2009. These two roughly tend to move in tandem, but the stock market is often ahead of the curve given its forward-looking nature. So while economic data may look great today, markets may move against that (and may currently be doing so) at any time.
But market timing is not the answer either
Let’s look at the most recent two market crashes, the Dotcom bubble of the early 2000s and the Global Financial Crisis of 2008/2009.
The Dotcom Bubble was at its peak around April 2000 and at the bottom around October 2002. If you had been fully invested throughout that period you would have lost -37%. Yet an investor who would have started investing in April 1998, two years prior to the peak would have made a return in the run-up to the crash of +34%. An investor who would have gotten out a year too early and back in a year too early would have earned +18% (1999-2000) and -20% (2000-2001). That nets to -2% which is pretty much the same as what an investor who sat out the ride would have earned.
The pre GFC markets were at their peak around October 2007 and at the bottom around March 2009. If you had been fully invested throughout that period you would have lost -46%. Yet an investor who would have started investing in October 2005, two years prior to the peak would have made a return in the run-up to the crash of +28%. An investor who would have gotten out a year too early and back in a year too early would have earned +11% (2005-2006) and -38% (2008-2009). That nets to -27% which is far worse than the -18% you would have made if you had just stayed put.
In case of the GFC:
- It would have taken an investor who entered in March 2005 until November 2009 to break-even (55 months)
- It would have taken an investor who entered in March 2006 until October 2010 to break-even (54 months)
- It would have taken an investor who entered in March 2007 until January 2012 to break-even (57 months)
Market timing can make a small difference, but getting it right is hard and the possible impact on investor returns tends to be skewed to the downside if anything.
So what are the changes you *can* make to your portfolio?
I would basically recommend three things.
- Set aside a small allocation to assets that will protect you from a market crash. I have worked out an example portfolio that makes heavy use of gold, long Japanese yen (a safe-haven currency) and US Treasuries in combination with so-called defensive equities. Alternatively, if your portfolio has a shorter time horizon, focus on lower volatility with as much yield as you can find
- Put your money in high conviction themes: Once the sell-off starts, it will likely be indiscriminate. In order to feel peace of mind, invest your money in companies or themes that you see value in for the long term. Stocks may crash today but water scarcity and demand for healthcare are likely to be topics that play out far into the future. Invest in those.
- Sell down casually as markets move up, and start buying casually as markets move down. Since timing is hard, the solution is to average up and average down. If in every of the first 6 months of a year markets are up 1%, and you sell down 1% of your portfolio, while in the second year markets are down -1% every month and you add back 1%, you end up at 0%. If you hold on to your portfolio in the same period, you end up with a loss
Rebalancing: a suggested portfolio that will withstand the worst
A suggested portfolio to cope with the worst of the next market shock could be a combination of several of the themes that I have worked out on this site. For instance you could allocate as follows:
- 25% Low Risk High Yield (40% equity)
- 25% Market Crash (12.5% equity)
- 12.5% Trade War (30% equity)
- 12.5% Rising Interest Rates (50% equity)
- 25% Healthcare, Robotics and Automation, Frontier Markets, Water Scarcity, Travel and Tourism (5% each, 100% equity)
On the whole, this portfolio works out to nearly 50% equity, you could scale it up or down based on your risk appetite. But note that in many cases (e.g. the Low Risk High Yield portfolio) the equity is lower risk than the broader market already.
The above portfolio maintains upside through exposure to risky assets and in the 2008 Lehman Brothers default period (14 September 2008 to 14 October 2008) scenario would have returned about -12.6%. In the same period most stocks lost more than -20%.