Saturday, February 21, 2015

The Next Market Crash may Not be Far Away!

Today, a lot of uncertainty exists in the market and January 2015 started with an increased amount of market volatility – especially for commodity oriented investors.  Diversification into the U.S. markets should have helped mitigating the ups-and-downs of our own Canadian TSX. As discussed earlier the U.S. dollar is in rocket trajectory compared to other currencies and many commodities appear to be in free fall. The U.S. market peaked in December 2014 and today seems to be a good time to revisit the topic of market cyclicity and diversification.

Have a look at stock market patterns as described in an older post. At first sight, bull and bear markets seem to be cyclic, but the underlying fundamentals of the markets seem to change every day.  To see parallels between the 1970s and today, as many gurus have done is kind of naïve.  It assumes that history repeats itself and thus is cyclic.  If that was true, the world would move in circles without real progress.  That is a simplistic view – to think that life today is just like some 30 or 40 or 100 years ago is absurd. Today’s world is entirely unique– just think of our technological progress; about our life expectancy; about our lifestyle!  Think about progress in human rights and many other areas and you must admit that these gurus are comparing apples with oranges if not with strawberries.
Our productivity on earth has gone up and every step we’re taking is into a new frontier. Yet certain things seemto be somewhat repetitive, for example the ups and downs of stock markets.  In August 2011, we reviewed significant market rises and falls and noted several patterns. See Bull and Bear Market Analysis  Below, I have updated the table in that post.
Table of market peaks and lows between 1929 and today
It shows that the average market cycle lasts 3.6 years and that the longest market cycle, since 1929, lasted 7.17 years. That was during the 2nd world war when the market rose 123%.  The bull market starting in Feb 2009 has now lasted just over six years and after the 2002-2007 cycle it is the third longest on record.  So is there a trend that recent market cycles last longer?  Not really, but it shows how rare those very long cycles are. Having experienced two of the longest bull markets (except the one during World War II) in a row is probably even more unusual.

Market Cycle Duration. Vertical axis = duration of each cycle in years versus time starting in 1930 until today.
Top that off with the fact that the Dow Jones has risen close to 155% from its low in February 2009 and you may start to realize that the U.S. market is at rarified heights. The odds in favor of a bear market coming soon are high.
Here is another matter to consider: Most economies on the globe are currently not performing very well. Canada has been OK but not exactly stellar over the last number of years. This is especially so when you omit the resource sector.  The U.S. economy is currently one of the strongest in the world and that is reflected in the U.S. dollar.  Europe is quite weak, although with the European Central Bank becoming increasingly aggressive with its own version of Quantitative Easing, Europe's economy and stock markets may be ready to catch up.  The strong U.S. dollar on the other hand may lead to reduced U.S. exports and reduced profits for U.S. based multinational companies such as GM, GE, Microsoft, JNJ, Apple, etc.
While around 2008, geographical diversification did not help soften the blow by the financial crises to stock portfolios; now many countries seem to have economies that dance according to their own drum.  Compare Russia’s economy to that of Canada; the U.K. to that of the EU; etc.  This time geographic diversification may be important for protecting your stock portfolio.
How can we translate all this in a less volatile and more prosperous portfolio?  I guess, today proper diversification is very important. Both by geography; sector and by asset classes such as gold, cash, real estate and of course fixed income. Many world renowned investors over and over stress the importance of diversification, including diversification of asset classes.  However, over-diversification, or diworsification as it is referred to by Peter Lynch, is likely to result in underperformance as well.  Are we caught between a rock and a hard place? 
For the coming years, I would stop adding to your U.S. portfolio because of the earlier mentioned concerns.  I would prune that portfolio down to market dominators such as JNJ, Microsoft, Apple and other high quality, dividend paying juggernauts. De-risk this portfolio segment and then let your profits ride. What about just owning a S&P500 or Dow Jones Index ETF such as DIA or XSP (Canadian dollar hedged) as an alternative? Use a tightened stop loss of 15% and let this segment ride out the bull market. Quite often excellent profits can be made in the last stages of a bull market, but you may have to be nimble – like musical chairs – to get out in time. Hence the stop loss. I suggest to have no more that 25% of your ‘investment paper portfolio’ in U.S. markets.  Remember from other posts, that investment paper such as stocks, bonds and cash should not make up more than 50% of your total net worth.
The Canadian energy sector is, along with many other resource sectors, in bear market territory.  I am hopeful, but not certain that this market sector has bottomed. But other sectors of the Canadian market such as the financials, telecom and even real estate trusts are high if not too-high priced. Do not jump with both feet into the resource sector; wait for a clear improvement of prices. You may not catch the bottom – but it is probably better to wait until the next bull market in resources is well on its way – a technical break-out could be the buying signal. Be underweight in dividend paying large caps such as the banks or companies such as Brookfield. Alternatively, only own this market segment through an ETF that mimics the TSX60 (e.g. XIU-T). So hold 25% of your investment paper portfolio in Canadian stocks of which 15% in an XIU like index fund;7.5% (which is overweight) in high quality energy companies such as PEITO, CNRL, and Suncor and 2.5 in an Materials ETF.
Own 5-10% of your investment paper portfolio in physical gold (the global non-fiat currency) and another 15% in cash. You can build your cash by simply not reinvesting incoming dividends and other distributions, including net cash flow from your rental real estate holdings if you own those (see later on).  When you sell off stocks, do not reinvest but first build your cash position and re-invest the remainder according to the investment paper portfolio described in this post.
Now, we have close to 65-75% of your investment paper portfolio allocated.  Next we’re putting 5% in a German ETF and another 5% in a West European ETF to benefit from a recovering Europe. The remaining 15% should be going to fixed income. Possible a 3 year laddered GIC portion (5%) and a short term bond portfolio using an ETF such as XSB (10%).
Paper investments are investments that you don’t control such as stocks and bonds.  This is typically the most liquid portion of your portfolio and should not exceed 50% of your total net worth. The rest of your net worth goes, amongst other assets, towards your personal residence or home. We can write whole assays of how to buy your personal residence.  That is beyond the scope of this posting. I suggest you buy the family house you need to lead a pleasant but not an opulent life. The rest of your net worth should be invested in rental real estate.  If you don’t want to do the rental management yourself, get a good rental manager or participate in a rental pool.  Don’t invest in qualified investor joint ventures – they make often lots of money for the general partner and very little for you.
Also, if you work in a city like Calgary and you work for a local economic pillar like the oil industry, consider carefully your true diversification.  When employed by the oil industry, owning rental properties indirectly influenced by that same oil industry and investing a stock portfolio heavily weighted towards oil and gas companies does not represent a well-diversified portfolio J   The more experience I gain as an investor, the more I realize that your business or employment income ought to be considered an important part of your total net-worth portfolio. We will revisit this topic in later posts.
I think that we should fortify our portfolio for some near future volatility.  I don’t say ‘Sell everything and run for the mountains’.  However, structure your portfolio as described above. Ensure you have the cash flow to avoid any forced selling during rough markets, which in an extreme case may include the loss of your job.  Like a gardener, prune and weed your portfolio gradually until it has the portfolio structure that you desire. Never forget Asset allocation is often more important than the selection of individual stocks.  In fact, Warren Buffett suggests that rather than owning a portfolio of stocks his heirs should be better off by investing in a series stock market index ETFs.
BTW. Recently Tony Robins,  motivational speaker extraordinaire, showed another side of himself with an excellent book on personal finance that I highly recommend: 'MONEY Master the Game'.

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