A Perfect Tale

“1,2,3,4-We Want More”Perfect Storm wealth management

A few years back a gentleman that was at the time living in my hometown wrote a book called The Perfect Storm.  It was about a series of events that led to a disaster at sea.  I promised myself that if I ever saw a combination of events that led to a perfect storm equivalent in the stock market that I would write about it.  This is A Perfect Tale because it talks about the combination of events that has led to over a 25% drop in the Dow, the S&P 500, the Nasdaq and every other major stock index around the world over a 3-week period.

Please note, for all those investors and clients of advisors that still believe in modern portfolio theory, efficient frontiers, Gaussian distributions, mean-variance analysis, traditional asset allocation, static rebalancing, Monte Carlo simulation, etc.—the events of the last 3 weeks should be extremely disturbing and if you are honest with yourself, should make you rethink your strategies and methodologies because your beliefs have been proven wrong since what has actually happened can’t happen.  Unfortunately, those that don’t learn from their mistakes are doomed to repeat their errors and when reality confronts beliefs or better said, contradicts beliefs, the normal tendency is to disregard reality.  In the financial markets, this particular type or cognitive dissonance or disregard of reality can be quite costly and yet when this period ends, and it will end, a period that is conveniently assumed incapable of existing, we will once again hear the familiar yet completely incorrect refrains.

I urge all of our readers to contact us and request a copy of The Sera Capital Management Guide to the Stock Market as well as The Sera Capital Management Guide to Portfolio Management to see an alternative approach that is more in line with reality and how markets and people actually function.

The subtitle of this tale is 1,2,3,4-We Want More and is a tribute to what the Johns Hopkins band plays after every goal scored by the beloved Blue Jay lacrosse team.  After the 4th goal for example, they play a little tune and then chant-1,2,3, 4 we want more.  I guess they’re greedy.  I’ve always loved this tradition and thought I would incorporate it in this tale, but not because we want more but because in this case—we want less.  We want less bad news.  4 events that created this perfect stock market storm is enough. What were these events?  They are, the corona virus, the Federal rate cut, the drop in oil prices and the press conferences from Chancellor Merkel and President Trump.  Here is how we break things down.

  • It’s February 19th and there are grumblings about this potentially disruptive thing called the corona virus. But it’s a distant threat as the S&P 500 closes at all-time highs.  Over the next few days, the media catches on to the increasing threat the virus poses and the stock market starts to notice as well as it slowly moves down while volatility is rising.  The news accelerates and the market starts a steady decline while volatility has a steady up swing until,
  • In a surprise move on March 3, The Fed cuts interest rates by ½ of a percent. The initial reaction is one of euphoria as the stock market soars only to quickly reassess and changes direction under the guise of–the Fed must know something we don’t know.  That very day, sentiment changes in what is called a reversal day and the market closes at a loss for the day.  We see the 10-year US government bond interest rate drop precipitously. The next few days are characterized by large moves up and down in the stock market with technical traders looking at support and resistance points until,
  • Monday March 9th, Saudi Arabia and Russia can’t come to an agreement on oil production levels and the price of oil plummets and the Dow closes down approximately 2000 points on the day. At one point, the rate on the 10-year falls below 0.35%.  Stop for a second and think about what this means.  It means that if you were to invest $100,000 in a 10-year bond, it would pay you roughly $350 per year.  This is a historic low and has deep and severe implications for those that depend on income from their portfolios.
  • On March 11, Chancellor Merkel lets the world know that based on best evidence, as much as 70% of the German population will be infected by the corona virus and that we are in a “spread out” action phase. That evening, President Trump announces the restriction of travel from Europe for 30 days and the markets react both on the 11th and the 12th with European equities down approximately 11% on the 12th and US equities down almost 10% by the close of trading

This brings the February high peak to March 12th close drop at 28.3% for the Dow, 26.9% for the S&P 500 26.8% for the Nasdaq, 24.0% for emerging markets and 27.8% for developed countries outside of the US.  Let’s analyze what a diversified portfolio of these 5 worked over the last 3 weeks.  If you picked the best one, you were only down 24.0%, the worst one you were down 28.3% on average you were down 26.8%.  What does this tell us?  It tells us that major stock averages behave the same under duress, that they exhibit a correlation coefficient of almost 1 and that the best way to achieve diversification would have been through the allocation of part of your capital to bonds or cash instruments either on February 19, 2020 or along the way as adaptive strategies do.

This is a 1,2,3,4 punch that gave us a perfect storm and thus A Perfect Tale.

So great, we’ve described what’s happened, but that’s history.  What can we expect next?  As always, our answer is no one knows for sure but what we’ve learned over the last 40 years of investing is to protect capital by reducing risk during these periods.  Please note, we had to overcome our cognitive dissonance as well to get to where we are today.  What we’ve also learned, is that we have to execute capital protection in a systematic, objective, rules-based fashion.

How do we do this?  Most of our readers know that we allocate a good part of our client portfolios to what we call adaptive strategies or strategies that can change their composition from stocks to bonds and then back to stocks depending on economic conditions.  We’ve interviewed countless adaptive managers and have settled on a variety of ETFs or subadvisors that have clearly defined rules that we can understand and we let them follow their rules.  We know exactly what to expect and we make certain that their methods are not correlated to each other.  What we accomplish by doing this is we eliminate emotion from the equation and as anyone that is going through periods like this understands, during emotional times people lose discipline which can create situations that keep them from achieving their financial goals.

As we write this tale, we can say that of the six adaptive strategies we follow, each one was 100% invested in the stock market on February, 19, 2020.  Fortunately, that is no longer the case.  One strategy is 100% out of stocks already, two others are under 50% invested in stocks, 2 others are still fully invested and one is fully invested but is hedged with equity puts and volatility calls.  This is exactly the type of non-correlation we expect.  A different way for the reader to think about adaptive strategies is to imagine that you’ve put together a number of stop-losses on the equity part of your portfolio.  So maybe one of your strategies sells stocks after a 5% drop, the other after a 10% drop, etc.  By so doing, you are systematically reducing the risk of significant losses because you are systematically selling stocks based on a formula.  We feel very comfortable with this approach and once again we urge anyone that wants to learn more to request a copy of The Sera Capital Stock Market Guide as well as The Sera Capital Portfolio Management Guide.  But be warned, neither guide is for the novice investor.  While we like to write tales with a minimum of charts, tables and graphs as we did in our book Financial Tales, it’s not the case with our two guides.

So, what’s the main takeaway of this tale and what does this mean to one’s future?  In most cases, especially if you are a long-term capital appreciation driven investor, the perfect storm is just one of the many bumps you will experience along the way.  Stick with your plan as long as it’s a good one.  We encourage our readers to request The Trampoline Effect if you are looking for a good, simple to follow strategy.

But what if you are living off of the income your portfolio generates?  This is an entirely different story.  You see, while we have had a rather harsh downturn in the stock market, there has been a substantial upturn in the bond market.  As of this writing, the US 30-year bond is paying about 1.40% the 10 year about 0.85% and shorter maturities are even less.  The question then becomes, is it possible to collect the same levels of income as before without increasing the risk of my portfolio?  The answer is no and not just no but a resounding no.  This leaves income dependent investors with three choices;

  • Reduce your income while maintaining risk constant or,
  • Maintain income steady and maintain risk constant which means a slow, consistent and predictably reduction of the principal of your portfolio or,
  • Maintain income steady and increase the risk of your portfolio to potentially maintain your principal while recognizing that your portfolio will be more volatile than before.

Each individual must decide on which of these choices suits their situation, but what is clear is that when rates essentially go to zero, those dependent on income are in a difficult situation.  None of the 3 choices is a good one when compared to history and these types of investors are being forced to enter a brave new world.

Some potential increased income and risk solutions should investors opt for option 3 above are limitless.  We have our favorites and soon we will publish a tale about what’s happened in the energy industry as well as in the institutional real estate industry as ways to execute strategies for those that choose option 3.

We leave you with a paradox and the best proof we know of why people need to change the way they view investing, especially those that need income.  There is a piece of software that any financial planner/advisor/VP of some large bank or brokerage firm can get for a few bucks a year that runs “what if” simulations on the probability of someone having a successful retirement outcome.  I mentioned it earlier and will mention it again, it’s a Monte Carlo simulation but in the hands of someone that doesn’t know how to interpret the results, the results are worthless.  These simulations are typically performed for those individuals that are recently retired and want to understand the amount of income they can receive based on a certain portfolio allocation so that they don’t outlive their assets.

Let’s look at what Monte Carlo tells us.

  • Tom is 65 and retired on February 19, 2020 with $1,000,000 and wants to receive an inflation adjusted income of $40,000 per year. Tom’s portfolio consists entirely of stocks and when the simulation is run, out comes a sentence that says, “With this asset allocation Tom, you have a 90% probability of not running out of money over the next 30 years.”
  • Jerry is 65 and also retired on February 19, 2020 with $1,000,000 and wants to receive an inflation adjusted income of $40,000 per year. Jerry’s portfolio consists entirely of money markets and cash instruments when the simulation is run, out comes a sentence that says, “With this asset allocation Jerry, you have a 10% probability of not running out of money over the next 30 years.”

Let’s fast forward to the close of business today?  Jerry still has $1,000,000 while Tom has $750,000.  We run a Monte Carlo again and Tom’s probability of a successful outcome has dropped but not appreciably while Jerry’s is still at 10%.  In the meantime, Jerry has $250,000 more than Tom.  Ask anyone, who has a higher chance of success today and they will tell you Jerry because he has more money.  But Monte Carlo can somehow see into the future and know that Jerry will only keep his money in cash while Tom will keep his money in stocks.  This is the paradox and points to the fact that Monte Carlo simulations have no way to measure a dynamic trading model and uses rudimentary assumptions based on past performance.  If you see one of these playing at a theatre near you, time to go to a different venue.

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