5 rules for surviving a bear market
For those that have never seen, or forgotten what a real 'bear' market looks like (and we can use the standard definition of one, which is any time the stock market drops by 20% or more) - here are 5 rules that we consider when managing your Rosecut investment portfolios:
1. Don't take too much risk
OK, let's start with the obvious one first. Thinking of speculating on that small oil exploration company? Maybe picking up an extra 1% yield by buying junk bonds...? Not a good time. If ever there is a time that these investments could go to zero - it's now.
Prioritise funds holding many underlying investments, that use little to no leverage (debt) to boost returns.
It's also not the best time to overweight the equity portion of your portfolio. Government bonds and cash are usually your best defence against a deflationary slowdown.
How Rosecut have followed this:
All our clients hold diversified regulated fund with no leverage. Our equity weights have been at or below usual levels, and we've had plenty of cash and government bonds.
2. Stay liquid
What do we mean by liquid? We mean investments that can be bought and sold easily, without moving the price.
For an example of an illiquid investment, we can look at direct property funds such as the M&G Property Fund, which is still closed, along with every other direct property fund. By 'direct property fund' I'm referring to those which invest directly into commercial property buildings. They are not fast things to sell and yet sell they must, when clients demand redemptions.
Investors in these funds cannot get out of them, and the fund managers will be forced to accept unfavourable pricing if they try to sell any buildings.
The ultimate example of a liquid investment is cash. A couple of the worst days of the crisis occurred when investors around the world were desperate for cash, particularly dollars. On those days - everything sold off, even government bonds. The only thing that rose was the dollar index, as people hurried to buy dollars.
We know that holding too much cash over the long-term is a bad idea, but if you can make a tactical call to hold some before a bear market - you give yourself the option of using it later to buy cheaper shares.
What Rosecut has done:
Our property investments are in an ETF that tracks the shares of companies engaged in commercial property. These can also fall in value in a bear market but at least they can be bought and sold throughout every business day.
Going into the bear market of 2020, we held 14% in cash with similar weights in government bonds. As the stock market fell to cheaper levels, we then started using the cash in the Rosecut investment portfolios.
3. Be agile but do not over-trade
This is a tricky balance to strike. Trying to second guess every twist and turn of the market is a good way to rack up trading costs and, most likely, lose money as the market is difficult to predict on a day-to-day basis.
A better approach is to remain patient, have a sensible plan for when you are going to add back equities, for example, and what you will be looking for.
To illustrate this, consider the point at which we rebalanced portfolios and went overweight equities.
In our plan, we had been waiting to see:
Large monetary and fiscal stimulus - tick
The corporate bond market showing signs of normalisation - tick
Stocks turning in two positive sessions (i.e. trading days) - tick
Signs that the economic consensus (i.e. economists, fund managers, strategists) were bearish - tick
...And ideally stocks would still be a long way from their highs with room to recover - tick
None of these guarantees that a bear market is truly over, but having a sensible plan leads to better decision making - which over time, is what generates better results.
4. Recognise regime shifts
The market of the recent past, isn't always the market we have today. For example, over the past ten years the market has been one practically under-written by the Federal Reserve. Every time stocks fell in a major way, the Fed loosened monetary policy (i.e. cut interest rates or carried out quantitative easing) and stock markets bounces back.
This all changed when the pandemic led to an immediate shutdown of major economies. Cutting interest rates, which is the standard central bank response has some drawbacks - mainly the time lag. It can take around 9 months to 2 years before interest rate cuts impact the real economy.
When the Fed cut base rates by 50bps, at the very start of March 2020 - the stock market continued to fall. This was a new regime, where the playbook of the last 10 years was not going to change things. Over the next two weeks, stocks and corporate bonds fell dramatically. If you hadn't recognised a change in regime at the time, then you were buying back-in far too early. This regime needs large fiscal stimulus - which has an immediate effect.
At Rosecut we recognised this regime shift once we saw the stock markets still moving down after the rate cuts. We had to manage money in a different way. Specifically, we didn't buy back in equities, we didn't even rebalance the Rosecut investment portfolios until we saw fiscal stimulus announced. This helped protect the downside for clients and meant when we finally did rebalance (after the US announced a $2 trillion fiscal stimulus) we were buying at much cheaper levels, using cash to fund the purchases.
5. Understand gamma
OK, I know this is a technical term from the world of options trading* - but bear with me...I would like you to imagine two assets. In the initial phase of a sell-off, asset #1 is down 10% and asset #2 is down 3%. On the surface, asset #2 looks like a defensive and diversifying asset.
Then comes the second phase of the sell-off. Asset #1 is down 10% (again) but this time asset #2 is down 10% as well. Essentially, asset #2 is suffering an acceleration in losses. We could describe asset #2 as suffering from gamma risk. That defensive and diversifying asset doesn't look so good now.
It's only in meaningful sell-offs that gamma risk gets exposed. Most of the time, the majority of people don't even notice it exists.
Perhaps the best example of this can be found in the structured products that private banks sell to their clients. Some of the most popular ones would be sold on the basis that they can only lose money if markets fall by 40% (for example). Because these structured products are manufactured by using derivatives - including options; their valuation derives from the price of the underlying market.
When the market first starts to fall, the price of these structured products barely moves. This is because a 40% drop still looks like a remote possibility.
However, when the market continues to fall, and a 10% drop becomes a 20% drop - the probability of it going all the way down to 40% or more, looks a lot higher.
As a result, the structured products suddenly start losing money fast.
This is gamma risk being exposed.
How does Rosecut deal with this?
Well firstly, we don't deal with derivatives, including structured products (which often contain a lot of hidden costs, but that's another story).
We also seek to avoid asset classes that could display these characteristics in a bear market. For example, high yield bonds - when the corporate bond markets stop functioning properly and you have forced liquidations, high yield bonds are vulnerable.
If you'd like to read a more detailed definition of gamma risk, check out the following link:
Summary:
All the rules above are ones that we find useful in guiding our decision making. While they will no help call the exact bottom or top of the stock market, they help us construct client portfolios that survive bear markets.
I can't recall where the following quote comes from, but I think it sums things up well:
"I can't tell you when a storm might hit. But I can build you a portfolio that will weather any storm."
If you would like to see the portfolios we run for clients, click Sign up on our website and create a personal profile with Rosecut today. In addition to having a portfolio managed by a former private banking team, you can easily construct a personal wealth balance sheet, and lifetime cash-flow projections to guide your important financial decisions.
The value of an investment and the income from it can go down as well as up and investors may not get back the amount invested. This may be partly the result of exchange rate fluctuations in investments which have an exposure to foreign currencies. You should be aware that past performance is no guarantee of future performance.
