For those that have never seen, or forgotten, what a real ‘bear’ market looks like (and we can use the standard definition of one, which is any time the stock market drops by 20% or more) – here are 5 rules that we consider when managing your Rosecut x Dolfin portfolios;
(1) Don’t take too much risk
OK, let’s start with the obvious one first.
Thinking of speculating on that small oil exploration company? Maybe picking up an extra 1% of yield by buying junk bonds…? Not a good time. If ever there is a time that these investments could go to zero – it’s now.
Prioritise funds holding many underlying investments, that use little to no leverage (debt) to boost returns.
It’s also not the best time to overweight the equity portion of your portfolio. Government bonds and cash are usually your best defence against a deflationary slowdown.
How Rosecut have followed this:
All our clients hold diversified regulated funds with no leverage. Our equity weights have been at or below usual levels, and we’ve had plenty of cash and governments bonds.
(2) Stay liquid
What do we mean by liquid?
We mean investments that can be bought and sold easily, without moving the price.
For an example of an illiquid investment, I can point you towards an article I wrote recently on direct property funds.
The M&G Property fund is still closed, along with just about every other direct property fund. By ‘direct property fund’ I’m referring to those which invest directly into commercial property buildings. They are not fast things to sell and yet sell they must, when clients demand redemptions.
Investors in these funds cannot get out of them, and the fund managers will be forced to accept unfavourable pricing if they try to sell any buildings.
The ultimate example of a liquid investment is cash. A couple of the worst days of the crisis occurred when investors around the world were desperate for cash, particularly dollars. On those days – everything sold off, even government bonds. The only thing that rose was the dollar index, as people hurried to buy dollars.
We know that holding too much cash over the long term is a bad idea, but if you can make a tactical call to hold some before a bear market – you give yourself the option of using it later to buy cheaper shares.
What Rosecut has done:
Our property investments are in an ETF that tracks the shares of companies engaged in commercial property. These can also fall in value in a bear market but at least they can be bought and sold throughout every business day.
Going into the bear market we held 14% in cash with similar weights in government bonds. As the stock market has fallen to cheaper levels, we have started using this cash in the Rosecut x Dolfin portfolios.
(3) Be agile but do not over-trade
This is a tricky balance to strike. Trying to second guess every twist and turn of the market is a good way to rack up trading costs and, likely, lose money as the market is difficult to predict on a day to day basis.
A better approach is to remain patient, have a sensible plan for when you are going to add back to equities, for example, and what you will be looking for.
To illustrate this, consider the point at which we rebalanced portfolios and went overweight equities.
In our plan we had been waiting to see:
- Large monetary and fiscal stimulus – tick
- The corporate bond market showing signs of normalisation – tick
- Stocks turning in two positive sessions (i.e. trading days) – tick
- Signs that the economic consensus (i.e. economists, fund manager, strategists) were bearish – tick
- …And ideally stocks would still be a long way from their highs with room to recover – tick
None of these guarantees that a bear market is truly over, but having a sensible plan leads to better decision making – which over time is what generates better results.
(4) Recognise regime shifts
The market of the recent past, isn’t always the market we have today.
For example, over the past ten years the market has been one practically under-written by the Federal Reserve. Every time stocks fell in a major way, the Fed loosened monetary policy (i.e. cut interest rates or carried out quantitative easing) and stock markets bounced back.
This all changed when the coronavirus led to an immediate shut down of major economies. Cutting interest rates which is the standard central bank response has some drawbacks – mainly the time lag. It can take 9 months to 2 years before interest rate cuts impact the real economy.
When the Fed cut base rates by 50bps, at the very start of March – the stock market continued to fall. This was a new regime, where the playbook of the last 10 years was not going to change things. Over the next two weeks, stocks and corporate bonds fell dramatically. If you hadn’t recognised a change in regime you were buying back in far too early. This regime needs large fiscal stimulus – which has an immediate effect.
At Rosecut we recognised this regime shift when we saw the stock markets still moving down after the rate cuts. We had to manage money in a different way. Specifically, we didn’t buy back in equities, we didn’t even rebalance the Rosecut x Dolfin portfolios until we saw fiscal stimulus announced. This helped protect the downside for clients and meant when we finally did rebalance (after the US announced a $2 trillion fiscal stimulus) we were buying at much cheaper levels, using cash to fund the purchases.
(5) Understand gamma
OK, I know this a technical term from the world of options trading – but bear with me*
I would like you to imagine two assets. In the initial phase of a sell off, asset 1 is down 10% and asset 2 is down 3%. On the surface, asset 2 looks a defensive and diversifying asset.
Then comes the second phase of the sell off. Asset 1 is down 10% (again) but this time asset 2 is down 10% as well. Essentially asset 2 is suffering an acceleration in losses. We could describe asset 2 as suffering gamma risk. That defensive and diversifying asset doesn’t look so good now.
It’s only in meaningful sell off’s that gamma risk gets exposed. The majority of the time, people don’t notice it exists.
Perhaps the best example of this can be found in the structured products, that private banks sell to their clients. Some of the most popular ones would be sold on the basis that they can only lose money if markets fall by 40% (for example). Because these structured products are manufactured by using derivatives - including options: their valuation derives from the price of the underlying market.
When the market first starts to fall, the price of these structured products barely moves. This is because a 40% drop still looks a remote possibility.
However, when the market continues to fall, and a 10% drop becomes a 20% drop – the probability of it going all the way down to 40% or more looks a lot higher.
As a result, the structured product suddenly starts losing money fast.
This is gamma risk being exposed.
How does Rosecut deal with this?
Well firstly, we don’t deal with derivatives, including structured products (which often contain a lot of hidden costs, but that’s another story)
We also seek to avoid asset classes that could display these characteristics in a bear market. For example, high yield bonds – when the corporate bond markets stop functioning properly and you have forced liquidations, high yield bonds are vulnerable.
All the rules above are ones that we find useful in guiding our decision making. While they will not help call the exact bottom or top of the stock market, they help us construct client portfolios that survive bear markets.
I can’t recall where the quote below comes from: but I think it sums it up well
“I can’t tell you when a storm might hit. But I can build you a portfolio that will weather any storm”
Create your personal profile with Rosecut today. In addition to having a portfolio managed by a former private banking team, you can easily construct a personal balance sheet, and lifetime cash flow projections to guide your important financial decisions.
*If you’d like to read a more detailed definition of gamma risk check out the following links: