In calendar 2017 the US S&P500 increased 24% and the ASX200 increased 6% both with unusually low degrees of volatility. And dividend income flowed of course. Fast forward to 2018 and the markets should be drug tested along with the Commonwealth Games athletes on the Gold Coast. It’s all changed. So far this year the S&P500 has declined 6% and the ASX200 has fallen 4%. What has really been different has been the return of volatility. We are quite frequently getting daily swings of 1-2% up and down. What does it all mean? Is it the end of smashed avocados for breakfast? Is it the end of western civilization as we know it? Does it mean the dreaded bear is returning?
There is little doubt that we currently have most of the conditions that have historically been present when previous bear markets commenced. Just trying to cheer you up here. These include the length of the upturn in the Australian and US sharemarkets (pretty well since the end of the GFC). Calendar 2017 was the first time that real total returns from all major asset classes for Australian investors (Australian shares, international shares, bonds, listed and unlisted commercial property, housing and gold) went up for six straight years. It has all been fueled by very low interest rates. And the rising tiding has lifted all boats. Both poor and high-quality companies have performed well with little discrimination between the two.
Investors have migrated away from the low returns on cash and term deposits to riskier asset classes (Bill Shorten’s dividend imputation ruminations are a potential spanner in the works there). There are potential excesses e.g. Bitcoin and new world record prices in art, wine, coins and other collectibles. Most good quality businesses in the Australian market have been trading at prices well in excess of what appears to be a reasonable value. The CAPE Ratio (a measure of over or undervaluation) in the US is higher than at any time since the late 1800s apart from the tech boom in 2000. Margin lending (borrowing to invest in shares), particularly in the US, is at record levels.
Also worth considering is that the long-term returns from asset classes sooner or later revert to the mean i.e. if there has been a period of above-average returns (as has been the case for many asset classes) at some time there is going to be a period of poor returns. A high CAPE Ratio has historically been a good predictor of poor future returns. Unfortunately, it doesn’t help in predicting when the next period of poor returns i.e. when the markets roll over will start.
However, these conditions have been present for at least a couple of years now and could quite easily exist for another two or three years before the next negative market. On the other hand, we could get a bear market this year. Or the next bear market may even have started. That is not for mere mortals like us to know. However one can be proactive in managing the risks of down markets.
There are two key aspects to bear markets. The first is that the value of our portfolios decline. Boo hiss. However good quality stocks tend to continue to pay income and recover their value when sentiment changes. Poor quality businesses that do not have favorable longer-term prospects and are overvalued (the trilogy in Lifestyle’s investment demonology) either don’t fully recover their value or only do so after many years.
The second (and often overlooked) aspect of a down market is that for some quality shares you only get the opportunity to buy them at a reasonable price in a general downturn. And this is where we should be focusing.
So the key to investing in current markets where the risks have substantially increased is to have a part in part out approach. Ignoring the risks will sooner or later result in tears. The traffic lights can go from green to red without amber so we are kidding ourselves if we think we can identify when markets will turn. Selling out of markets completely also isn’t recommended. It wouldn’t have been a great strategy over the last couple of years and for all we know the next bear market may still be some time away. Also there is a significant income penalty from being too conservative. No point losing not a single dollar because of what happens in markets if you run out money because of inadequate returns.
If you have an asset allocation strategy for your portfolio (x% in defensive investments and x% in growth assets you should make sure you are not overweight growth assets. If you are you should consider rebalancing your portfolio. You should also make sure that at least some of your defensive assets are truly defensive in that they will retain their value in a downturn. This means that you will have funds available to take advantage of any better than average opportunities that may present themselves. This really means cash and term deposits despite the current low-interest rates. Most fixed interest funds (it does depend on the particular fund), mortgage funds and income securities (hybrids) don’t cut the mustard here. In the GFC in 2008 and 2009 many fixed interest or mortgage funds were frozen and income securities fell 5% to 10%. They later recovered their value however it was too late if one wanted to invest when the best opportunities were there.
So while we don’t know when markets will turn we can position our portfolios to mitigate the risks. Far better to do this than try to work out which Trump tweet will lead to disaster or whether bond yields will continue to rise or whether Lady Gaga will cease to have fewer followers on Twitter than the Pope. To be prepared for the possibility of down markets you should be able to identify in your portfolio where the funds will come from to take advantage of any better than average opportunities that arise. Bear markets are not to be feared. On that note, it must be time for another dubious connection between the investment world and music. As the Blue Oyster Cult sang (lyrics possibly slightly changed).
All our gains are here. Here but now they’re gone
Seasons don’t fear the bear market. Nor do the wind, the sun or the rain
We can be like they are. Don’t fear the bear market
We’ll be able to fly. Don’t fear the bear market.
Sage advice indeed from the Cult. And a great guitar riff to boot.
Well, that’s enough for today. It should be noted that this blog contains no recommendations it is just providing information and comment. You should seek advice if you are considering buying or selling any investments. If you would like to discuss with me anything on this blog you are welcome to do so. Contact details are at www.lifestylefstas.com.au