Wintertime Is Coming

8 Things That Concern Us Today

When the next bear market arrives, we believe it will be longer and deeper than many expect. There are eight specific worries keeping us on high alert:

With these contributing factors, the next bear market decline will likely be longer and deeper than investors expect. For example, a decline of 50% is not out of the range of likely outcomes, given the risks listed above.

Adding to the pain of such a decline is the fact that, unlike previous market events, the Fed has little room to lower rates, and even less room to print money given the large size of their balance sheet.

While it is difficult to gauge the timing of the next market downturn, there is little doubt that such an event is coming. To prepare for this inevitability, we must position our portfolios in a way that will allow us not only to navigate the storm but also to be ready to step into the fray and take advantage of the opportunities that will undoubtedly present themselves.

It’s easy to look back on important market events and say, “That was the tipping point.” But it’s not so easy to anticipate the tipping point ahead of time. Instead of trying to predict these tipping points, we try to identify market environments that are susceptible to tipping points.

Today’s environment is marked by high risky asset returns and low volatility. We have stimulative monetary policies, aggressive fiscal policies, and a market that’s dominated by systematic and rules-based trading strategies.

When we’re in such an environment, we’re more cautious with our portfolios. We are looking for ways to reduce the risk of loss when that a tipping point moves from just around the corner, to dead ahead.

And in pursuit of this protection, we think of two things.

First, we think about the wealth-destroying downside. We characterize this as equities being down 30% to 50% and going through an extended period of sideways action and many false starts.

Second, we think about ways to implement this downside protection. The standard tools for managing downside risk, such as buying put options, can be very expensive.

Thus, we have to come up with other ways to get downside protection—ways that aren’t so costly.

One way to manage downside risk when we find ourselves in an environment that’s rich with possible tipping points is to turn to our trusty moving average crossover signals. Say what you will about moving average crossovers, but there is no denying that reducing exposure to risky assets when the market is in decline will offer at least some protection from the downside.

Those who argue against using a moving average system will say that it’s great to get out of the way of a big decline in the market, but how will you know when to get back in? It’s a fair point, and one that we address in our moving average crossover strategies.

The first thing is to recognize that no strategy will get you out at the top, and back in at the bottom. But that’s not what we are trying to do. We want to get out before most of the damage has been done and get back in before most of the recovery has taken place.

So, for example, in a market decline of 50%, we will gladly give up the first 10% on the way down, and the first 10% on the way back up, for a net savings of 30% of the damage. This is not only possible in theory, it has been achieved by our clients over several major bear markets.

When the market drops sharply, rules-based strategies call for action and begin the process of de-risking. That can take several forms. For one, it can mean selling the most vulnerable holdings in the portfolio. The time to think about which holdings are the most vulnerable is before the market starts to decline, not after. That’s why we routinely review our portfolios and rank each position in order of most to least vulnerable to a bear market event.

Our job is to take smart risk, not to eliminate risk altogether. And to do that, we have to calibrate how much downside risk we’re willing to take, how much we need to offset, and how much we’re willing to pay for it.

Join us next time as we explore another defensive strategy that has worked effectively for our clients: hedging. Prior to the arrival of inverse ETFs, investors had to buy put options, or sell short, in order to hedge their long exposure. But today this process is much easier. We’ll have details in the next installment of this series.