Draining the Swamp: Dealing with Current Market Volatility.


By John Nicola, CLU, CHFC, CFP

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There is an old saying that, “when you’re up to your neck in alligators, it’s easy to forget you came to drain the swamp.

Given the current market conditions, alongside major geopolitical tensions and U.S. political drama it is easy to understand how one might be more focused on the alligators than the swamp.

I am writing to you at this time to outline the myriad of reasons to have concerns, along with information and evidence, as to why our diversified asset allocation model along with a disciplined approach to planning and rebalancing is even more critical in times such as this.

Let’s consider just some of the concerns;

  • 2018 has proved to be a volatile year for equities and bonds. As of Friday, October 27th all major markets were in correction territory from their peaks (a drop of 10% or more). In the case of China’s CSI 300 the drop is almost 30% since January 24th of this year. The S&P 500 has lost 10% since late September as has the TSX since early July.
  • Even those individuals who chose to invest in a more conservative portfolio of 60% equities and 40% bonds will find their YTD results in negative territory (-2% or more net of fees).
  • Notwithstanding all of this, stocks are not particularly cheap after these corrections. The S&P 500 is at one of the highest levels in history when measured by the Cape Shiller 10 year trailing PE ratios.
  • It has been 10 years since we experienced a recession or a sustained bear market in equities. It would not be unreasonable for one or both to occur in the near term.
  • Geopolitical issues such as the threat of trade wars, immigration and the rise of populist governments could easily impact global economic growth. Early warning signs from many companies suggest that even the current level of tariffs are being felt in both the U.S. and China.
  • While markets are showing weakness, the overall economy is holding up well for now with relatively high growth and low unemployment, especially in North America. Central banks are increasing short-term rates with intentions to keep doing so for the foreseeable future. That has narrowed the spread between short-term and long-term bonds in the U.S. from more than 250 bps points in 2014 to about 28 bps points today. We are getting much closer to the possibility of an inverted yield curve where short-term rates are higher than long-term rates. In the past that has been a reliable predictor of a recession.

You would be forgiven if you thought I had changed my thinking to the dark side and now see every glass as half empty.

Nevertheless there are more than a couple of things to be concerned about and being prepared for the worst is a good approach to take in markets such as these.

This is a good time to remind all of you why we have the asset allocation model we do and what action steps should be taken as events unfold.

  • We have an asset allocation model that assumes there will be major corrections in asset classes. We have also found by sticking with a disciplined approach to maintaining a diversified asset allocation model and eschewing market timing that better long-term results are achieved with less volatility. Since 2000 our composite client  returns have been 7.05% annually after fees or 2.5% /year higher than Morningstar’s Neutral Balanced Portfolio (4.52%)(Morningstar.com, 2018*). Both as of August 2018. Over the shorter term in 2018 our NWM Core Portfolio Fund is about 3% higher YTD as of October 26th, 2018 vs. a 60% equity /40% fixed income portfolio such as the Morningstar Neutral Balanced Portfolio.
  • Our belief is that market timing does not work well consistently. So it is better to maintain the right diversification and rebalance regularly. This worked extremely well with REITs in 2008/2009 and preferred shares in 2015/2016. Our core equity exposure is currently less than 33% and a reasonable amount of that is partially hedged with a combination of puts and calls .
  • Even when markets experience major declines, the impact on dividend flows tends to be far less (so cash flows being generated by a diversified portfolio remain far less volatile than the price of some of the asset classes). This is true even when the portfolio is 100% equities. In the 2008 Financial Crisis the S&P 500 dropped just over 50% from peak to trough (October 2007 to February 2009). However the dividend yield rose as prices fell from 1.87% to 3.23%. In absolute terms dividends were about 18% lower in 2009 than in 2007. They quickly recovered and by the end of 2017 (+10 years later both prices and dividends were 80% higher than at the end of 2007). Results would have been even better if an investor was reinvesting dividends and re-balancing on a quarterly basis.
  • It is far easier to plan on being disciplined in a crisis than to be that way when the crisis occurs. Studies from groups such as Dalbar consulting out of Boston and Vanguard (one of the world’s largest asset managers) prove that, over time, poor investor behaviour has a far greater impact over time than fees on wealth building.

Time will tell if we are really up to our necks in alligators, but whether now is the moment, or it occurs later we will certainly experience bear markets and recessions in our investment life.

Having the right asset allocation and wealth building strategy is what will allow you to survive and thrive in environments such as this.

 

*(as at Oct 26, 2018. Morningstar.com. (2018). Morningstar Direct | Morningstar. [online] Subscription data available at: https://direct.morningstar.com)

 

 

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