Why the market’s about to drop – and what I’m doing about it

Posted on by FIRE v London

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.

Apparently US company earnings are falling, and, not unsurprisingly if so, dividends are heading down. This hasn’t happened before, since, well, just before the last market correction/crash/similar.

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.

Image result for hills in london
Head for the hills! If you can get a spot – this is London after all.

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:

Image result for world equity markets since 1900

So, nothing to see here. Get your fix somewhere else.

Unless you think I’ve missed something? Please say!

28 thoughts on “Why the market’s about to drop – and what I’m doing about it”

  1. I’m not doing anything either, so no comment on that. Do you really think you should hold your age in bonds? (I would guess not unless you are aged 19).

    How are your bonds allocated (gov/corp, UK/US/EUR/EM etc.)? Any high yield or linkers? Also, don’t you have any alternatives?

    Liked by 1 person

    1. I think the ‘your age in bonds’ is a reasonable rubric, yes – i.e. in your 20s, long term investments can be 80:20 Eq:FI, and in your 70s the mix is more likely to be 25:75

      My bonds are allocated, geographically, in line with my ‘target allocation’ that I publish widely/frequently on my blog. e.g. https://firevlondon.files.wordpress.com/2019/07/image-3.png

      The biggest bond holding is a Barclays Global Beta ETF/Fund, which has a mixture of Local / Government / High Yield. After that it is Gilts, Index tracker ETFs, and then (smaller) direct holdings, high yield funky things, etc.

      Barclays Wealth Global Beta Port Fund 17%
      Barclays Index-Linked Gilts ETF 7%
      iShares FTSE UK All Stocks Gilt ETF 6%
      Vanguard Total Bond Market ETF 5%
      Random fixed income (high fee, private bank sold!) Private Equity Fund 5%
      iShares Core USA Aggregate Bond ETF 5%
      VANGUARD SCOTTSDALE FUNDS LNG-TRM CORP BOND ETF 4%
      PFF iShares Preferred Stock ETF 4%
      Vanguard USD Corp Bond ETF 3%
      iShares Corporate Bond ETF 3%
      SPDR BARCLAYS HIGH YIELD BOND ETF 3%
      Barclays Bank 7.125% Undated Sub Notes 3%
      iShares III Plc Iboxx Corp Bond Ex-Fin ETF 3%
      ….

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      1. I think you need to stick with stocks your whole life. The max SWR comes from a 75% equity allocation, so unless you retire late or very rich, you need a lot of stocks.

        The problem in London is that property is so expensive that it eats into your stock allocation. I’ve never been able to get anywhere near 75%.

        The only time you need a lot of bonds/cash is just around the time you switch from accumulation to decumulation when you have the maximum risk from the sequence of returns.

        (Also, you didn’t mention alternatives, so I guess you don’t have any).

        Liked by 2 people

  2. Tricky, innit – and one’s own psychology becomes a big factor. One thing I have found helpful, is to set myself a specific financial target for how much wealth I actually *need* in order to sustain my current lifestyle for the foreseeable. Thus while I dislike the idea of missing out on the potential gains of rising equities, I feel that the closer one approaches that target the more defensive one should become. Whilst there’s always room for a little more wealth, maintaining a high return strategy under such circumstances feels likely to benefit the tax man more than one’s self…

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  3. My policy which I have stuck to for decades is not to do anything. Accepted wisdom is that most people cannot read the markets well and I accept that i cannot. So I simply stay in the market with about 70% exposure to equities.

    Liked by 1 person

    1. Amen to that. Nonetheless, the accepted wisdom also suggests (compellingly) that the higher one’s exposure to equities, the more volatility one should expect. A view could be held that deciding to hold 70% equities is far from ‘doing nothing’ (not that I’d argue it is wrong, per se)

      Liked by 1 person

  4. unfortunately, unless you are able to liquidate all your investments (like by paying off your mortgage and not caring about its value) you can’t escape the fact that as the stock market moves up and down and from boom to bust that your fortunes will change with them.

    like @Kurtz says, we aren’t good at reading the markets on average and the best thing to do is to go with the flow.
    I’m sticking with my plan of buying over time – this could be the top but you’ll never know until you are looking at it with rose tinted glasses in the rear view mirror.

    Liked by 1 person

  5. Hi FvL,
    Would it be possible to stave off the crash until sometime after I’ve bought a house?
    Its been a nice little run since Dec2018 for sure which has been great for my house affordability sums.
    Maybe I’ll come to rue my impending leverage experiment though?

    Liked by 2 people

  6. Timely post as I’ve just decided that I’m going to up my bond allocation a bit, so aiming for around 30% bonds, which is what feels comfortable for me (previously 10%).

    As to whether it’s right or wrong for me, I’m sure I’ll find out when the bottom falls out of the market!

    Liked by 1 person

  8. I think it’s important to keep in mind that threshold-based stock:bond rebalancing (as I’m sure you’re doing!) gives some protection against big market crashes – both on the way up and the way down. I was surprised you didn’t mention it in the post.

    I think that unless you get lucky, this is the best protection most people can hope for.

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  9. Hey, great post.
    •How did you decide your asset allocation? 95% of nmv is a lot a equity
    •Why not get your leverage from spreadbetting? The tax free returns make it well with it for me.

    Liked by 1 person

    1. By 95% I actually meant 93%…..
      My Investment Policy Statement logs changes to my allocation, if you’re interested. In a nutshell….
      I started off in 2012 as 77/19/4 Equities/Bonds/Cash.
      In 2016 I then leveraged up to buy my Dream Home. This was a fairly risky move so I also moved away from Equities and towards Bonds. This left me at 100:50:-50 (which is effectively 2:1 equities:bonds, and 33% leveraged).
      Then I have slowly deleveraged and back towards equities. Notably when the Brexit ref boosted equity values, I moved to 100:40:-40 (i.e. 5:2 equities:bonds, 29% leveraged), and then in 2018 with the sale of some illiquid assets I moved to 95:25:-20 (19:5, 17% leverage).
      I am right now at 93:20:-13, i.e. only 11% leverage, but as equity-rich as I have ever been.

      Finally – spreadbetting – interesting idea – one I haven’t looked into, though I’ve always been frightened by the ‘almost every spreadbetting customer loses money’ stats.

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      1. It strikes me that some alternatives would help. Gold, Reits, infra, real assets… Pounds are cheap to borrow, so you could increase leverage if you don’t want to cut equities.
        The fact that large numbers of day traders lose money doesn’t put out me off spread betting. That’s the reason is tax free btw. Just don’t day trade.

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      2. I do have some Reits but lump them into my Equities bucket. Gold is not for me. Owned property is not in my ‘investable portfolio’ but I do have some – just not tracked here.

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  10. I began investing in equities in 1986. In thirty-three years, I have had nine losing years of which only three were worse than 10%, i.e. 2001-2002 (-27%) and 2008 (-23%).
    If you are anticipating losses on this scale then your problem is when do you run to the hills and when do you run back. If you are expecting losses of less than 10% then I think you need to be able to stay invested. I prefer to stay invested on the basis that any losses will be recovered eventually.

    Liked by 2 people

  11. It’s a Personal decision of course, dependent on your appetite for risk. I personally hold too much cash on my asset allocation for that reason. But miss out on potential gains. However can sleep easier with this. You dont need super gains and will benefit from reduce volatility so sounds good.

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  12. The logic in this post seems pretty shakey to me. You’re assuming that you can predict market movements ahead of time which seems highly unlikely.

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    1. I think you’re suppoosed to look at this post with a decent amount of irony 😉 (correct me if I’m wrong, FvL?)

      Liked by 1 person

  16. Interesting post. I’ve also pondered my actions what to do in the event of things going bad in a way which is transparent to me.

    As someone who has tried timing the market selling almost everything (am broadly 100% equities no current leverage) and rebuying over the following few months (early 2018) as the terrible didn’t materialise. Luckily this exercise didn’t cost me too much (transaction costs and a few lost dividends) and taught me that I at least can’t time the market for toffee and that broadly neither the the bears or the bulls have any real clue what will happen next any more than me other than that in all likelihood in the long term equities will more than beat inflation.

    My previous behaviour and prior to my timing experiment – what I’d generally done in all previous crises (some equities held since 1999 but a meaningful amount the last decade) is to remain invested and check portfolio once a week instead of daily and wait it out/continue buying on normal schedule.

    What I will change this coming time is to change to some slightly more defensive options eg (switched iii to hgt which performed better and recovered faster during financial crisis) broadly leave everything else alone to avoid transaction costs. If I recognise free fall I will make new purchases in an opening ended defensive fund (am currently favouring Sebastian Lyon Troy Trojan O) for the duration of the downward spiral. I hope this will limit downside but avoid touching bonds or trying to market time. Once the broader indexes reach -30% or thereabouts I will consider a bit of leverage and switch back into my normal motley collection of ITs and equities.

    Will see how it goes I guess. I’m reasonably confident I won’t get the fear and sell out as when I did so before it was in an effort to make more money rather than avoid losing it.

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  17. Interesting post

    As someone who has tried timing the market selling almost everything (am broadly 100% equities no current leverage) and rebuying over the following few months (early 2018) as the terrible didn’t materialise. Luckily this exercise didn’t cost me too much (transaction costs and a few lost dividends) and taught me that I at least can’t time the market for toffee and that broadly neither the the bears or the bulls have any real clue what will happen next any more than me other than that in all likelihood in the long term equities will more than beat inflation.

    My previous behaviour and prior to my timing experiment – what I’d generally done in all previous crises (some equities held since 1999 but a meaningful amount the last decade) is to remain invested and check portfolio once a week instead of daily and wait it out/continue buying on normal schedule.

    What I will change this coming time is to change to some slightly more defensive options (switched iii to hgt which performed better and recovered faster during financial crisis) broadly leave everything else alone to avoid transaction costs. If I recognise free fall I will make new purchases in an opening ended defensive fund (am favouring Sebastian Lyon Troy Trojan O) for the duration of the downward spiral. I hope this will limit downside but avoid touching bonds or trying to market time. Once the broader indexes reach -30% or thereabouts I will consider a bit of leverage and switch back into my normal motley collection of ITs and equities.

    Will see how it goes I guess. I’m reasonably confident I won’t get the fear and sell out as when I did so before it was in an effort to make more money rather than avoid losing it.

    Liked by 1 person

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