What portfolio construction strategies are best suited to handle a possible bear market? That question has been looming larger for advisors and investors alike.
When the U.S. stock market plunged in mid-January, global oil prices were crashing and Chinese stocks had dropped into bear territory. On American soil, signs of fear crept in as investors digested a Federal Reserve rate hike, commodities prices fell and voters faced the prospect of a bizarre presidential election cycle.
On what was arguably the worst day for the markets, Jan. 15, when oil settled below $30 a barrel and U.S. retail sales and industrial production data signaled economic weakness, portfolio manager Laif Meidell decided to move his actively managed exchange-traded fund 100% into cash.
“Support was breaking down in the market,” said Meidell, president of Reno, Nevada-based advisory firm American Wealth Management and portfolio manager of the AdvisorShares Meidell Tactical Advantage ETF (MATH). “It will be a day-by-day process of evaluating trend reversal before we go back in.”
At the same time, Michael Kay, a certified financial planner and president of Financial Life Focus, a fee-only independent registered investment advisory firm in Livingston, New Jersey, was busy reminding his clients that they had worked with him to craft a goals-based financial plan designed to weather periods of volatility.
“The time to change your allocation is when you have a clear view of your particular needs and wants,” Kay said. “If you’re risk averse, it’s not prudent and appropriate to go to all cash in a bear market. I’m telling clients, ‘You just want to turn off Fox Business News and turn on “I Love Lucy” or “The Golden Girls.” Find things that will make you laugh and not cringe, and know we’ll get through this.’”
Theory vs. Practice
Portfolio management in a tumultuous market isn’t an easy job. It’s a time when managers’ resolve on asset allocation strategy gets tested and advisors field calls from clients who worry whether their investments are well positioned. What seems simple in theory becomes more complicated in practice, but putting these pieces together can mean the difference between overreacting and selling out of asset classes at the wrong time.
Technically speaking, a bear market happens when an asset class declines at least 20% from its peak, while a correction represents a drop of 10%. On Jan. 12, nearly half of the S&P 500 Index was in a bear market while the index as a whole slipped in and out of correction territory, according to a MarketWatch report. Just as troubling, the index fell more than 8% in the first three weeks of the year while international stocks in Japan, China and the U.K. had all officially entered a bear market.
What does a bear market mean for advisors and their clients? It means properly adjusting a portfolio for risk and an understanding of financial goals and time horizons. That may involve adjusting the percentage of bonds in a portfolio upward and focusing more on blue chips. And it also means making a rational choice of asset classes before a bear market ever hits.
“Investors should know what they own,” said David Santschi, chief executive officer TrimTabs Investment Research, Sausalito, California. “A lot of people have been reaching for yield and taking on risk, but they don’t know what they’re buying. Even since January, asset prices are still very high historically: stock, bonds, real estate and collectibles. Assets have been expensive for a long time and they still are.”
Knowing what to own in a bear market is tricky, Santschi added. Cash and higher-quality bonds are among the best safe harbors in this period of volatility, he said. “Commodity prices have come down a lot but price action isn’t good, and it could stay like that a long while. I wouldn’t be bullish on gold or energy, especially oil.”
Commodities: Yes or No?
Commodities should be viewed as a trading vehicle rather than an investment choice, according to Ritholtz Wealth Management Chief Executive Officer Josh Brown and Director of Research Michael Batnick.
“We don’t include any slots for commodities in our asset allocation models and we never have. It’s not that they can’t go up, or that we predicted the current rout — it’s that long-term portfolios work just fine without them and their benefits as a diversifier have been overstated by the fund industry,” Brown wrote in a post for his blog, The Reformed Broker, on Jan. 13.
Batnick said people who are hell-bent on gaining commodity exposure would do better buying stock funds. For example, he noted, 8% to 10% of the S&P 500 is in the energy sector while 3% is in the materials sector. Further, many emerging markets countries and companies are correlated to commodity prices.
Along with commodities, high-yield debt, or junk bonds, have taken a tumble. Commodities companies are major issuers of junk bonds, to the tune of 27% of the market in 2014. Further, Third Avenue Management liquidated its Third Avenue Focused Credit fund in December, further tarnishing the high-yield market.