Why the market’s about to drop – and what I’m doing about itPosted: 2019-07-24
This time is different.
We’ve been at market highs before. Staring at unprecedented multiples, unhinged presidents, central bankers finally increasing rates, comedians winning elections in G8 economies, the first serious trade wars in decades, and more.
We’ve heard how a big drop is imminent before. We’ve muttered, whispered, tutted, gawped and clicked our tongues.
Yes, as we predicted those times, market corrections often followed soon after (except, just a couple of times, when they didn’t).
But this time really is different.
This time my portfolio is running red hot, at a new high water mark.
Amazon’s just crossed $2000/share. $2000, per solitary share.
In the UK, the (120,000) people have spoken and we have a new Prime Minister. And Brexit no deal/etc looming on Hallowe’en’s day. As if the world economy wasn’t giving us enough to think about.
So, obviously, now is the time to run for the hills.
Which hill to run to?
Fix 1: Reduce leverage
Obviously, the last thing you’d want to be when the market drops is leveraged.
I am leveraged.
My loan amounts to about 14% of my portfolio’s value. My portfolio is 95% exposed to equities. So a 30% drop in equities stands to reduce my portfolio by almost 30%. Ouch.
So, should I immediately de-lever? I have a bit of cash lying around, and I could sell some holdings very easily. It would be easy enough to do, and do quickly. And yet, almost because of how easily I could de-lever, I don’t want to de-lever yet. Leverage overall has helped juice my returns, and at 14% leverage I am not in any material danger of being ‘wiped out’, even in a brutal market crash.
Fix 2: Reduce exposure to equities
The rule of thumb for a balanced portfolio is a rising exposure to fixed income (bonds) with age. For example, holding one’s age, in percent, in bonds. I.e. I should hold around 45% of my portfolio in bonds. I do not do this; my target allocation is to hold 95% in equities, a further 22% in bonds; this adds up to 117% of my portfolio’s value, so I need to cover the 17% by holding debt (negative cash) of 17%. In effect I am 95:22 equities:bonds, which is a about 19% bonds, i.e. 81% equities.
Should I reduce from 81% equities? It is tempting, I will admit.
Amazon, at over $2000. Surely, a good time to take profits? Yes, maybe. As it was at $1400/share, only 18 months ago.
Yet despite Amazon’s heroic rise, Microsoft is toe-to-toe with Amazon vying for ‘most valuable company in world’ award. Its share price, which I bought at around $25/share, is up at $140/share. An obvious gain to realise, surely?
Facebook is back at $200/share. Yet it’s shedding users, being fined $5bn, and taking on every government in the world with Libra. Another one to sell?
The S&P500 is about to hit 3000. It’s not done that before. Surely, time to rebalance?
If those stories about earnings heading only downwards are true, equities are going to be a very different investment for the next few years.
On the other hand, the FTSE 100 is still lolling around in the mid 7000s – which it’s becoming very familiar with.
And how come Berkshire Hathaway, which is something of a proxy for ‘good non-tech (AMZN and AAPL notwithstanding – Ed.) American businesses’, is still lurking around the $200/B Share mark that it’s been at since the end of 2017. That is not a very clear Sell signal, given Berkshire’s prodigious capacity to grow earnings year after year.
And don’t equity markets always anticipate the next recession, not vice versa? If so, it’s too late to sell based on the earnings forecasts.
Fix 3: Increase ’emergency fund’
With markets about to fall, the sensible thing to do is increase my cash-at-hand.
Except that I already have quite chunky ‘3 months spending’ funds, in a couple of currencies. So there isn’t much to do here, thankfully.
But with all my overseas exposure, perhaps I should bring money home. To the UK, and keep it parked in trusty pounds sterling. Or, perhaps, not.
Fix 4: Time to buy long term bonds
I may not hold many bonds, but I also hold a ragbag mixture of them. I haven’t entirely kicked my habit of buying high yield bonds. And I hold some whole-market trackers.
But once the downturn really hits, central banks will cut interest rates – or make them even more negative in the case of the German bundesbank.
Bonds go up in value when interest rates (or, more precisely, the expectations of those rates) move downwards. And long term bonds move the most. So time to fill my boots on those then? Yes, around the margins.
Fix 5: Focus on defensive stocks
But hang on, when the market tanks, it will most likely be led by tech stocks as reality catches up with them, closely followed by global traders like German car manufacturers and Apple. Falling markets and falling dividends will sap confidence, leading to a drop in consumer confidence, which will ultimately hit ‘big ticket’ players like furniture retailers, car brands, and so on. And once the horns come in, spending drops, and unemployment rises. The woe spreads.
But of course there are plenty of businesses which do fine, rain or shine. The proverbial undertakers, the household products, utility businesses. And there are other businesses that, despite everything, are doing a roaring trade right now – the defence contractors selling navy ships that can patrol the Strait of Hormuz, for instance.
So maybe the time is to reduce my ‘passive investing’ bias and pick ‘winners’, or at least ‘less badly affected’ companies? SSE, BAe, Reckit Benkiser, those sorts of stocks.
It’s not really ringing true, is it?
Fix 6: buy protection against a sharp drop
With the US stock market reaching record highs, it looks set to be one to tumble. That would upset my zen. Maybe I should buy ‘protection’ – for instance by using Options.
As it happens, I don’t have an easy way of buying an Option for the UK market, so let’s focus on the USA here. With the USA stock market hitting record levels, this makes plenty of sense anyway.
I have a legacy holding, VTI, which is the Vanguard Total Stock Market ETF. Its price is over $150/share. So one form of protection I could buy is to buy a Put option, giving me the right to Sell VTI shares for 10% less than the current price. If VTI takes a savage tumble, of more than 10%, then this Option becomes valuable.
Right now, on my fanciest (and cheapest) broker, the price of a Put option to sell VTI in two months’ time, at 10% lower price than today, is about $0.45c. This is about 0.3% of the price of the stock; in other words if I was prepared to pay about a fifth of the dividend yield to provide some protection, I could insure against the chance of a 10% price fall over 2 months.
On an annual basis, i.e. doing this six times a year, executing this strategy would cost me more than the dividend yield (1.8%). This doesn’t feel absurd, but it would completely change my returns profile. Right now, it isn’t for me.
Summary – the fixes I’m doing, in the order I’m doing them
I’m thinking about this stuff. I’m writing a blog post, for ‘eavens sake.
And that’s all I’m doing. My strategy has been working pretty well for me. I can cope with a market downturn. I do not believe I have an ‘edge’ that means I know something the rest of the market doesn’t. My portfolio is pretty well tuned, and close to its target allocation. I am pretty well hedged, across countries, asset classes and so on.
[Edited, thanks to a comment from @cookyourselfrich] And one crucial element of my strategy would become very important, post the downturn – my rebalancing. My target allocation is to maintain 95% exposure to Equities; if Equities took a hammering (and assuming bonds didn’t), then I’d find myself way out of line from my target. And, until I returned to the target, all my reinvestment of income, whether dividends from stocks or coupons from bonds, would be deployed on buying Equities.
Buying when the market falls is nervewracking. An amateur mistake is not to do it. But ultimately Buying when something is Low is good practice; and, in the extreme, Selling when things are High. I’d rather do that than Buy High, Sell Low.
Of course, we’ve all predicted 19 of the last 2 market downturns. The US’s oldest index, the Dow Jones Industrial index, has had plenty of downturns in the last century and it is doing just fine:
So, nothing to see here. Get your fix somewhere else.
Unless you think I’ve missed something? Please say!