Are you prepared for the next market move?

• Whether you think we're in a bear market or just a short-term correction, this is a good time to review your portfolio and prepare for the next market move.
• Regardless of where the index is, a large number of companies are now deeply in bear market territory, and this has created some attractive opportunities for long term investors.
• In light of the recent drop, investors can afford to be slightly more aggressive in terms of their equity allocation and investing time horizon

Before last week began, we opined that the market was in need of some good news, otherwise the onslaught would continue. Unfortunately, we called it right, for the US market was down another 7% for the week. Thankfully, Canadian equities, which we all along said would do better in this environment, lost only 4.5%. Such loss is nothing to rejoice about, but when we called for focus on Canadian equities as one of "Five things to do in preparation for the next bear market", the idea was to reduce your losses, no more.

If you come across a bear in the wilderness, you do not panic and run. The same goes for investing. But are we truly in a bear market, or is this just a mere correction? Frankly, the nomenclature hardly matters. An 18% loss off the highs (16% for Canada) is severe, and more than half of the stocks (nevermind the index) are already in bear market territory (technically speaking, the definition of a bear market, for what it is worth, is a loss of 20% or more). The so-called FANGs are already deeply there, with losses ranging from 25% (Google) to 40% (Facebook and Netflix).

Having stated the obvious, i.e that selling in panic is never good, what's there to do if the spectre of further losses is looming? The last thing we would try to venture is a guess about what will happen tomorrow, or next week, or even next month. The only view we would offer is that the reasons that triggered this setback, namely tighter monetary policy, trade war rhetoric and fears of economic deceleration, remain unchanged. Moreover, this was all exacerbated last week by a couple of rather temporary factors, namely fears of partial government shutdown and more tax loss selling. For the market to reverse course and rebound from here, it needs a dose of good news on one or or more of these issues.

Good news often surfaces when we expect it the least. The market has its own way of proving people wrong. Any positive news regarding monetary policy, or the trade friction with China or Government shutdown will help. Moreover, as people head to their Christmas and New Year holidays, tax loss selling will slow down considerably and we are likely to see very light trading volumes for the rest of the year. So whatever market movement you see this week will be magnified because of low volume, and will not necessarily be reflective of future trends. For any meaningful indication on the latter, we have to wait for the next year. Given all that, it might not be a bad idea to put things on hold and go enjoy the holidays.

Still, year-end is always a good opportunity to reflect on things, including your investment portfolio. And there are opportunities out there now. As we said earlier, Canada has several attractive options for the income oriented investors, with companies in the financial, utilities and pipelines sectors currently trading at yields ranging between 4% and 6%. There are similar opprtunities in the US as well. So while you celebrate, there is nothing wrong with thinking about your next steps, or your next discussion with your investment advisor about your strategy and how to reposition your portfolio for the next year(s).

The only caveat is that, whatever you do, you ought to be prepared for the possibility (but of course not the certainty) of further turbulence. And being prepared is all about investment horizon and moral disposition. On that, let us remind ourselves of some basic fundamentals.

Over the long term, real return on equities has averaged 7% or so. However, it has never been a straight line upwards. We've had years of negative returns like this one. Granted, it is never pleasant to watch your wealth shrink the way it has this year, but the reality is that one has to be prepared for such setbacks because they are part of life. So while the short-term is highly unpredictable, the long-term is actually fairly predictable. In fact, the longer the term, the more predictable your return is. Yes, equities may well lose another 10% or 15%, or even more next year, or the market might recover its losses and resume its climb. Knows who? The only certainty is that equities always appreciate in the long term.

But just as we take solace from the predictability of long-term equities performance, we do caution against getting too excited during good times. In a previous update, entitled Dangers of the wealth effect , we covered this point in detail. If you get one year of 20% return on equities, it does not mean you can count on that in the future. To the contrary, this will always be followed, sooner or later, by years of lower return, or even losses, such that the market will always revert to the long-term mean of 7% or so. Thus you should always model your spending patterns and portfolio projections around this 7% assumption(or whatever percentage your advisor recommends, depending on your specific holdings /investment cost).

We never get tired of repeating our line that you should never bite more than you can chew, i.e. never put in equities any money that you might need in the short term. When you sell your equities, you always want to do it at a time of your own choosing. You never want to be compelled to sell (sometimes at a loss) because you need the money to pay for your son's tuition, or your daughter's wedding, or any other good reason. This is why investment horizon is of critical importance.

In our Introduction to the Maximum Equity Approach, published back in March of 2018, we said that most bear markets clear within a period of five years, and that such would be a conservative assumption to make for deciding on your time horizon. By that we mean you should be prepared to hold your equities for at least that much time, and not invest any money that you might need during that period. Most importantly, however, we argued that your time horizon should largely depend on where we stand in terms of the investment cycle. Today, the market has already lost 16%-18% of its value and many stocks, as we said, are deep into bear market territory. Therefore, if you invest (or add to your equity allocation) today and the market continues to drop next year, you will need less time to recover your losses, probably much less, than you did if you had invested at the market peak, back in 2017. For that reason, we believe most investors, except the ultra conservative types, might want to consider a shorter time horizon, say three years or so, in the current environment. This is something you need to weigh considerably, in conjunction with your investment advisor, because it also depends on your personality and your very specific personal circumstances, in terms of the size of your wealth, your spending patterns (and budget flexibility, etc.), your tax situation and other factors.

Whether you think that now is the time to buy, or that you ought to be prepared for further turmoil, you need to know which funds are best positioned for the next market move, whatever you think such move will be. If you think that the market will rebound, you want funds that are highly exposed to technology and other cyclical stocks. if you think the onslaught will continue, you want defensive funds with a relatively high cash balance, or funds that are exposed to defensive sectors like consumer staples, pharma, utilities or REITS (real estate). Do you think that commodity prices have bottomed? If you do, you want funds with high exposure to commodity-based stocks. To get funds with the highest exposure to the sector, or asset class of your choice, you can use our tool for sorting funds by exposure. It is very powerful, unique and it's free!

December 23, 2018

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