As always, stock markets experience corrections, some even turn into bear markets. As we say in our Guiding Principles on our website splash page, “Risk Management Is Critical To Your Success”. For this timely update, I’m going to do a deeper dive into the specifics of how, and to what degree, our various investment strategies do Risk Management, and we’ll finish with an action item for opportunistic investors.
The Purpose of Money
Importantly, all investors must remain focused on the primary goal and purpose of our money and that is to serve us in finding financial independence, covering our living expenses in retirement, and avoiding the risk of outliving our assets. As I’ve said in recent updates, I’ve seen a lot of bad behavior in market participants in the last 24 months angling toward get rich quick or entertainment and stock market gambling. We want our money to be boring. We don’t want drama. We want to fall asleep watching our investment balances rise consistently over time. Entertainment is easy to find at Netflix, Vegas, Sports, etc. Let’s all commit to having our money serve its true purpose and leave entertainment out of the equation.
Markets Continue Deep Correction
Certainly, a large swath of the financial market is already in a bear market defined as losses of 20% of more. Ask Cathy Wood, the know-it-all investor in all things “entertaining”. The Ark Funds are down over 60% since February of 2021 (not 2022) and falling 2-3% a day. But her funds are actually a nice representation of what’s been happening to a lot of investor capital in the last year or so. Fun fact, only 25% of all stocks in the NYSE are trading above a 200-day moving average as of yesterday. That number will be quite a bit smaller after today. The “200 day moving average” is a long-term trend indicator that effectively shows whether a stock, index or sector is in a bull market (above a rising 200 day) or in a bear market (below a falling 200 day). Said another way, even though the mighty S&P 500 is only down 11% YTD, over 75% of the market has already been in a heavy bear market experiencing losses of 20% or more. To be clear, while painful looking backwards, this creates an enormous opportunity looking forward. Who wouldn’t want to buy the bottom of a bear market? Well, there are a lot of things in deep bear markets now!
I don’t know when or where this correction ends. We do know that risk controls should be firmly in place for investment dollars that are dedicated to managing risk. In the short term, the markets are marginally oversold and sitting at a place and time where we might expect a bounce in prices. However, the vast majority of our intermediate and longer-term indicators suggest that there is still significant downside risk, and the burden of proof lies with the bulls. So, let’s get into how, where and to what degree, we manage market risk in our various strategies.
Risk Controls in Our Strategies
Understand that among our 11 different programs, we have two primary types of investment strategies in our firm’s offering. We have dynamic, actively traded strategies and we have constant exposure strategies that adopt a more passive approach. All are “risk managed” in their own rights so let’s dive into those distinctions.
Active Strategies (All Season, both Income models, Gain Keeper Annuity, Worldwide Sectors and New Power)
These strategies are best suited for tax deferred accounts where trading does not generate excessive short term capital gains. We have been working with our clients in high tax brackets for the last two years to move any taxable accounts into more tax efficient programs. Active strategies have the capacity to orient your investments incrementally and methodically into leading asset classes and securities while avoiding things that are unattractive for any number of reasons. As regular readers know, we have carried an absurdly large inflation hedge position in our All Season strategy by owning gold (IAU), silver (SLV), metals and mining (PICK), agriculture (RJA), commodities (PDBC) and energy (AMLP). All these securities are up strongly this year, several approaching double digit gains in a market that is now down double digits. In sympathy, we have carried a very small position in bonds for over 18 months. Bonds tend to do poorly, as they have, during inflationary cycles. Our stock positions have been relatively underweight and focused on value, select internationals and high dividend payers. Further, we have a volatility control allocation to securities that have very little correlation to the movements of the broad US stock market. Some of these are short positions that actually make money on down days. At the end of the day, our All Season strategy is barely down on the year net of fees. All Season and our Gain Keeper Annuity strategy have very similar approaches to dynamically shifting investment dollars among assets classes. Both strategies have very similar results YTD.
Other active strategies that are committed to stocks only like Worldwide Sectors and New Power, manage risk through selection criteria. Here we are working daily to invest in securities that have attractive valuations, are in the right sectors of the market and trending higher in price. That’s a tall order given the volatility in the markets. Naturally with any stock only program, one would expect higher volatility, but the risk adjusted returns here are far higher than the alternative of simply owning the whole market through any stock market index or ETF. Risk adjusted returns means returns are generated with much lower risk and volatility than our respective strategy benchmarks. For those who want to own stocks and do so with less risk of permanent downside losses, these strategies are great alternatives.
Finally, our Income strategies are also dynamic and actively managed for downside risk. Here we work only with bonds and income bearing securities as our universe of investible options. But we do have a great deal of choice. We can own Treasury bonds, which have been extremely unattractive for the last 18 months or we can swing all the way out to High yield corporate bonds which tend to act more like stocks. In the last year, sadly, the entire spectrum of bonds and income investments have been in downtrends. In these situations, we tend to just patiently wait in cash. Income strategy investors might have noticed a 40-50% cash position for most of the last year. Cash is a choice. Cash is an investment. Right now, we choose cash and are glad for it. But soon, possibly very soon, we will begin to deploy our cash as the set up for new buys is becoming more attractive by the day.
To be clear, risk management is not risk avoidance. None of our strategies eliminate risk. To do so would literally eliminate return. Our job is to actively orient assets into things that show better risk/ reward properties and have favorable price trends. We do accept some volatility along the way, but our downside losses should remain shallow, manageable, and recoverable within several months as they are today.
Constant Exposure Strategies (MASS Income, Wealth Beacon and Direct Indexing)
Constant Exposure is a nice word for a Passive investing style. Nothing is really passive as in held forever, so Constant Exposure is really a more accurate way to describe what we do. The idea here is that for accounts where trading securities might generate unwanted tax liability, we want to own securities for longer periods of time (in excess of 12 months) in order to generate long term capital gains. Even better, we might hold securities for years and push out any tax bills into future years. Gains are only taxed when securities are sold for a profit, remember.
Constant exposure strategies are intentionally designed to “Expose” assets to the full benefits of the stock market which does factually tend to rise over time. Market corrections, even bear markets are opportunities to act for these strategies. We can sell securities that are held at a loss, capture the loss as a tax credit and replace those securities with new positions – keeping our exposure “constant”. We can also use market corrections to rebalance our holdings. For instance, bonds have become a smaller part of our constant exposure strategies in recent months which the stock side has increased substantially. Now, as stocks are selling off, we can potentially rebalance our portfolios by adding to bond positions and bringing stock allocations back to their prescribed weightings. Market corrections also provide investors an opportunity to add to their constant exposure strategies just as any of us would take advantage of a desirable item that is suddenly on sale!
Our Multi-Asset Income strategy (MASS Income) is a bit of a hybrid approach that I find very attractive in the world of passive constant exposure approaches. Here we focus assets on high dividend and income generating securities across multiple types of securities (stocks, stock funds, closed end funds, REITS, preferred securities, mortgage bonds, credit bonds, etc.). The goal of this strategy is to remain invested (Constant Exposure) and generate a total yield of 6-7% annually. Price patterns and preservation of principle during market declines is a secondary consideration while we remain focused on the durability of the monthly and quarterly income distributions instead. Investment capital is the means of generating income and we need to stay invested in order to keep those checks coming! Think of it like a rental property. We always want to keep that property occupied with tenants who pay rent. This is very much the same approach using public securities while avoiding the time and energy of taxes, tenants, and broken toilets.
Of course, constant exposure strategies are going to realize the full upside potential of the market and the full downside potential so it’s critically important to make sure your allocations to these types of strategies is within your personal risk tolerance and capacity. Risk management is therefore light in these strategies and investors should not expect much principal protection.
Magic is in the Right Mix
One of our primary jobs as your advisors is to create the right mix of strategies for your situation within our offering. It is absolutely appropriate for most of our clients to have multiple strategies in play with representation from both Active and Constant Exposure camps. In times like these, active strategies do a great job of preserving capital and limiting losses. In raging bull markets, the constant exposure side of the mix carries the performance torch. When executed properly, the whole portfolio yields the desired results in risk control, tax efficiency, income generation and growth. THAT is when the magic happens, and your assets work to serve their real purpose in your life.
Short Term Opportunity – Calling All Cars!
There is a developing opportunity to add cash to the financial markets. The entire stock market is trading down in double digits now and the growth side of the market is down in excess of 40% or more in a lot of cases. Internally, speaking as the manager of most of our company assets, we are looking to get aggressive with our allocations and remove defensive positions (hedges and other securities) as prices continue to fall. We are looking for some indication that selling pressure is declining and that buyers are willing to step up. So far, we see nothing constructive, including today which has seen mushy, selective rebound following news of Russia’s invasion of the Ukraine. Lower lows and perhaps a few more uncomfortable red days (or weeks) could push this market into a deeply oversold condition that would be attractive. Regardless, this is A TIME AND PLACE, to consider adding new money to investment accounts.
Regular readers know that we issue a notice called Calling All Cars as an instruction to identify cash, move it in to investment accounts and start a shopping list of potential buys. This is that time! I will be doing the same for my personal accounts, planning to add to retirement accounts, kids 529 plans, and potentially starting a new direct indexing strategy on our new Canvas platform (happy to provide more details upon request).
It is time to act if you have sideline cash that you are interested in investing. Any new buys done on a DIY should be made judiciously and with good empirical evidence. There is never a day to sell all or buy everything.
That’s it for now, hoping to help you understand a bit more about how and to what degree we manage the risk in our clients’ portfolios.
Sam Jones
