The key to the decision to reduce portfolio risk was the steadily increasing volatility (VIX) index throughout the day. An early morning spike in the index suggested that the market would be able to handle the ratings downgrade with only modest damage; eventually the market stabilized at around -300 points. But then the volatility index rose to new highs as the market struggled to hold its ground. When the VIX index approached its old spike level, we executed trades to sell our exchange-traded fund holding, the only intra-day sale that was possible in the model portfolio. Even worse, as the afternoon progressed, the VIX index climbed to even higher levels, suggesting that there is a significant risk of another sell-off tomorrow morning.
With the market moving so quickly down, we felt the need to protect assets and increase the amount of cash on the sidelines.
So, if the market falls another 1,000 points from here – what is that, two days trading? – there will be enough money on the sidelines, in cash equivalents or in gold, to buy a meaningful position of stocks at the lower price levels. We’ve always said that falling stock prices feel a lot worse if you don’t have any cash on the sidelines with which to take advantage of the new, lower prices. We haven’t had enough on the sidelines, thus far. With the rising volatility statistics, it was time to have some dry powder on the side.
If the market rises 1,000 point tomorrow morning, the decision of when and how to reinvest actually gets much more difficult.
The easiest way to explain this market, which is selling off much faster than the economic fundamentals would seem to justify, is that the market is factoring in a new recession that isn’t yet evident in the economic indicators. Today’s updated May-Investments Leading Economic Indicator is, once again, pretty flat. Neither is the Conference Board’s LEI warning about an upcoming downturn. But the falling stock market and rising bond prices are typical of what happens during an economic recession.
The stock market looks very reasonably valued – unless a recession causes earnings estimates to dramatically decline. One thing we don’t want to do is sit still and watch the market decline 50%, as it did in the 2008 sell-off, and do nothing to protect portfolios.
The risk that the shattering of consumer confidence will result in lower consumer spending and a new recession cannot be ignored simply because the traditional Leading Indicators, nor the May-Investments indicators, are confirming the risk. We all know that the effective monetary policy for small businesses is tight. There is no more room for fiscal policy to stimulate. More off balance sheet borrowing by the Federal Reserve may just lead to more credit downgrades. Given the lack of stimulus options available, it wouldn’t be shocking for the economy to turn down and if profit margins get squeezed, then valuations can easily come down also.
As I’ve heard people say several times in the past few years, “hope” is not a strategy. “Stubborn-ness" is not a strategy. Our strategy is to “get out of the way of where it’s not working.” At market extremes, it makes sense to go contrarian. At this point, however, it seems to make more sense to follow our discipline, have some cash on the sidelines, and reduce risk while this credit market disruption plays itself out.
I still don’t think that the U.S. is the big problem. But the Asian and European markets closed before the worst of the selling hit the U.S. market, so they are likely to be selling off tomorrow and wondering which European sovereign debt rating (e.g. France’s Aaa-rating) gets lowered next. Also, most individuals own mutual funds, not stocks or exchange-traded funds, and Monday’s market close will be their first opportunity to sell out. Those trades will hit the market Tuesday morning and may explain the big sell-off late in the afternoon on Monday.
Reducing risk in the portfolio enables us to reduce the amount of “fear” in our own thinking about the portfolios. With money on the sidelines, falling prices become an opportunity to buy instead of just a painful reality. We can focus forward, on the recovery to come, instead of just looking backward and regretting missed opportunities to sell.
This is all part of investing in stocks. It is why stock returns, going forward, will likely be higher than those available to bond or cash investors. This is why we don’t want short-term money invested in stocks, and why we’ve been encouraging people to make certain that only “risk” money is invested in stocks. Sometimes, like today, having a discipline forces us to make decisions that we begin second-guessing the moment we execute the trade. Having a process reduces the impact of emotions on strategy, but it doesn’t eliminate the feelings of emotion – the responsibility for making buy and sell decisions about other people’s money. That’s all part of managing money.
But it would be much more difficult, and emotional, if we had no discipline at all.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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