As the markets continue to grow, we are often asked how investors should respond. Many still remember 2008 and how quickly the markets turned and want to be adequately prepared when a market correction occurs. While those conversations are best had with your financial advisor to make sure that your investment plan and the subsequent decisions are based on YOUR portfolio and retirement plan, there are some general ideas to consider.
With that in mind, we’d like to introduce you to Clint Sorenson. Clint serves as Sound Financial’s Chief Investment Officer through our partnership with WealthShield. When Sound Financial brought on the team at WealthSheild we added to our existing leadership team and broadened the skill set that allows us to better serve our clients. These partners provide the elements of our Rules Based Strategy that help investors make data driven investment decisions rather than news-cycle induced emotional decisions. Clint wrote an article for Forbes in December 2016 regarding market correction that still rings true today. To see the article directly in Forbes, you can go here, otherwise read below and contact your Sound Financial advisor to discuss what adjustments would be prudent for you and your overall retirement plan.
Protect Your Investments Now
Co-Founder at WealthShield
Current economic conditions indicate a U.S. stock market decline of 40% or more by the completion of this market cycle. The dramatic rise in asset prices since 2009 has caused an extreme overvaluation of the U.S. stock market. The levels of price to sales, Tobin’s Q Ratio, market capitalization to GDP, and cyclically adjusted price to earnings ratios have reached the point where bull markets end and bear markets begin.
As the chief investment officer at an advisor services company, I find that managing private client wealth and consulting financial advisors is quite difficult today. I started my career in investment management at a major firm at the peak of the last cycle in 2007 and never heard anyone at the company say to start preparing portfolios for the potential of a stock market decline. From my perspective, it seemed as if everyone was swept into the euphoria of the growing stock market. In hindsight, 2007 was a period not unlike today, characterized by high valuations and elation. In learning from the past, now is the time to start critically thinking about how to protect investment portfolios.
How should investors protect their portfolios? The answer is relatively simple. First, stop relying on traditional static portfolios. This approach could lead to devastating losses in today’s world of high correlations and central bank manipulation. In the global financial crisis, a 60% stock and 40% bond index fell more 34%. That is a big decline for a balanced portfolio and most likely one investors will not want to withstand.
Second, reallocate assets using a strategy designed to hedge and protect a portion of the portfolio from dramatic declines. Some of the most popular strategies that have historically produced positive returns during market declines are hedge funds, managed futures and trend-following strategies. Adding managed futures to a traditional portfolio would have historically benefited an investor from 1973-2015. However, there are some challenges associated with investor behavior.
When comparing a traditional 60% stock and 40% bond portfolio to a portfolio consisting of 40% stock, 30% bonds and 30% managed futures, it is evident that venturing outside the realm of the classic balanced portfolio may be beneficial. From 1973-2015, a $1 million investment in the 60/40 portfolio would have grown to just over $59 million. That is an average annual return of 9.94% with a maximum drawdown of 33.78%. Comparatively, the same initial investment over the same test period in the 40/30/30 portfolio would have grown to nearly $100 million. That is a return of 11.28% with a maximum drawdown of 20.28%
The value of incorporating managed futures is the ability to generate positive returns and protect assets during crisis periods. During the 1973-2015 test period, the 40/30/30 portfolio would have outperformed the 60/40 portfolio in every year that the market experienced a significant decline. For instance, in 1974 the 60/40 portfolio would have dropped 16.44% for the calendar year. The 40/30/30 portfolio would have gained 1.02%. In 2008, the 60/40 declined 23.17% and the 40/30/30 portfolio fell only 12.26%.
Historically, managed futures have demonstrated the tendency to protect portfolios during stock market declines. The reason that managed futures have had strong performance during periods of market turmoil is because of their ability to invest both long (betting on positions moving up in price) and short (betting on securities moving down in price). Therefore, when markets start moving down, managed futures traders can theoretically make profits by selling.
Maintaining an allocation that includes managed futures or other hedging strategies is often easier said than done. By studying the 1973-2015 historical data more closely, it’s easy to determine when problems with investor behavior would have occurred. From 1991-1999, the traditional 60/40 strategy would have outperformed the 40/30/30 strategy in all but two years. For investors focused on short-term performance, that is a difficult pill to swallow. History indicates that “herd behavior” would have had many investors abandoning their hedged strategies in favor of the more traditional strategy shortly before the 2000-2003 market decline that caused the S&P 500 to be cut in half. The same situation would apply to the 2003-2007 period before the 2008 financial crisis.
Where are we today? From 2009-2015, the traditional 60/40 portfolio outperformed the 40/30/30 strategy. This is the time to stand your ground. Prepare for a major market correction and silence the voice that’s telling you to focus on your short-term performance. The U.S. stock market became extremely overvalued as of the end of 2013. Mean reversion, according to Grantham, Mayo, Van Otterloo & Co., often takes around seven years to occur. That means that by the year 2020, stocks should fall to fair value. Now is the wrong time to abandon protective strategies.
Data Disclosure: WealthShield research utilizes data and information from public, private and internal sources. Sources include, Barclays Capital Inc., Bloomberg Finance L.P., Factset Research Systems, Inc., The Financial Times Limited, GaveKal Research Ltd., Global Financial Data, Inc., Haver Analytics, Inc., International Monetary Fund, Intercontinental Exchange, Markit Economics Limited, Moody’s Analytics, Inc., MSCI, Inc., National Bureau of Economic Research, Organisation for Economic Co-operation and Development, State Street Bank and Trust, Standard & Poor’s Financial Services LLC, Solactive, World Economic Forum, Thomson Reuters, Ycharts, NYU Stern School of Business, Yale University (Shiller Database), US Department of Commerce. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy.
Investment Advisory Services offered through Sound Financial Strategies Group, Inc. (“SFSG”), a Registered Investment Adviser. Certain representatives of SFSG are also Registered Representatives offering securities through APW Capital, Inc., Member FINRA/SIPC, 100 Enterprise Drive, Suite 504, Rockaway, NJ 07866 (800)637-3211. SFSG and APW Capital are separate and unrelated companies.
Posted on Tue, November 21, 2017
by Sound Financial