By Miles Clyne
The first quarter of 2016 was plagued with volatility (see chart below and area circled). At Tycuda we believe managing risk is at the heart of a successful investment strategy. We thought it would be timely to refresh both new and long-standing clients on how we managed risk going into this time frame and coming out of it. This update will discuss why we started moving out of equity positions in 2015 and why we have re-entered the market as of late March 2016. We e-mailed you a link to a more detailed webinar covering the same information included in this report. If you don’t have the e-mail, please contact us here and we will send to you.
As investors, we need to understand and manage volatility. To appreciate how negative volatility can be destructive to your investment plan, see the chart above which shows the Canadian stock market (S&P/TSX Composite) going back 10 years. The red line shows that the Canadian -index is still down about 12% from the high in 2008, and we are about on par with where the market was over nine years ago. Essentially, the Canadian market has flat to negative performance over the past decade due to corrections. We want to be is as confident as possible that our clients don’t experience the same results.
I’ll do my best to explain some of what we do at the Tycuda Group to reduce the risk associated with investing. But first, to help appreciate the impact losses have on a portfolio, investors need to understand the math associated with losing money. Below are two examples:
The first table illustrates that the greater the loss experienced by an investor, the greater return is needed to overcome that loss; a 50% loss necessitates a 100% gain to merely break even again.
The second table shows an investor who wants to generate a 15% annual rate of return. It illustrates what it would look like if they generated the return consistently each year vs. if in year two they lost 15%. You can see how significant a return they need to generate in the third year to get back on track after the loss.
It is pretty easy to see how quickly your investment plan could potentially go off track if you experience too much volatility in your portfolio.
There always seems to be danger in the markets that would keep us very wary. Some of the issues we are challenged with as investors at this point, as well as some of the positive points, are as follows:
- Corporate earnings have decreased for the last 3 quarters in a row.
- Energy typically does well through April, but with the appreciation we have seen another pullback is not out of the cards.
- Natural gas inventories continue to be very high.
- Negative deposit rates are causing many banks globally to struggle.
- It is difficult to be anything but negative on the Canadian dollar Vs. the US dollar because of our CDN interest rate policy, employment issues and commodity prices
- Mario Draghi, President of the European Central Bank (ECB) released aggressive monetary policy to stimulate the Euro economy.
- Decreased benchmark rate from 0.05 to zero.
- Increased monthly bond purchases to 80 billion from 60 billion Euros.
- Decreased the commercial bank deposit rate to minus 0.40 from minus 0.30.
- This appears very similar to the policies in the US after the 2008 financial crisis.
Within our stock trading strategies, we follow a disciplined technical process. The last thing we want to do is be drawn into a false rally, or stay in the market when there is too much risk. Determining whether the risk-reward is attractive for a given market or investment has always been very challenging for any investor. There isn’t a process for doing this absolutely perfectly. The goal at best is to be more approximately correct than not.
The graph on the top of the page illustrates SIA Charts technical analysis which they refer to as the Equity Action Call. It shows when they have identified when it is more prudent either be in or out of the markets. The Equity Action Call essentially measures supply and demand data across multiple asset classes. In other words, are there more buyers or sellers in the market? It stands to reason that we want to be buyers when there is enough support in the market to move markets higher and we want to be out of the markets when there isn’t.
The graph is very straight forward. When the line is in the green, there is a greater likelihood of having growth in the stock markets, so it is safer to invest. When it is in the yellow, it is unclear whether stocks will lead relative to other assets, so investors should be more cautious. When in the red, there is a greater likelihood that stocks will underperform other assets classes, so investors should exit the market of long only stocks.
The lower chart shows a few times of the many, when investing in false rallies could have been costly to investors. This is why it is critical to follow a discipline that is more successful than just staying in the markets, or trying to guess what is coming next. A higher level of predictability will not only give us better results, it will give us far more confidence.
Courtesy of SIA Charts we can get into more detail on the value of the Equity Action Call (see below). The first graph shows the signs of risk rising in the markets in August of 2015. At this time we started reducing our exposure to equities by not replacing any of the stocks that were sold in our portfolios. By mid-January of 2016, the risk had increased to where the indicator went into the red, and we exited all of our long-only stock positions.
On March the 14th the indicator moved out of the highest risk zone to where investors could consider investing if they were extremely cautious (the yellow zone). Our decision was to move in when we had we entered the least risky zone.
March 29th when saw a strong move back into the green zone. At this time we re-invested the cash we had been sitting on in the portfolios according to our process.
There have been 25 market corrections of 20% or greater in the US stock market (S&P500) since 1929. The average decline was -35% and the average frequency was every 3.4 years. Theoretically, we could expect substantial declines 2-3 times a decade. The above equity indicator can get us out of equities at a time when the markets happen to rise, but we view the loss of opportunity as a small price to pay for the opportunity to avoid substantial losses.
What is different now, given there still seems to be more cons than pros to investing at this point in the market?
- Major changes in leadership within the equity space
- Prior to exiting the market, leaders were in sectors like S&P 500, NASDAQ 100, Health Care, Aerospace & Defense
- Now we see a shift to Value, Low Risk, Consumer Staples, Utilities & Precious Metals
- Transition of leadership tells us that a material shift has taken place and has potentially resolved some major market uncertainty and that a corrective measure was not in vain
- The transition of leadership is what is so often overlooked. Investors fail to adapt to the market for many reasons:
- They are too large to move i.e.: multibillion dollar investment funds
- Belief that what worked before will work again (sticking with the same strategy that incurred the loss)
- “I’ll sell when my money recovers”…. investors get personal with their losses and hope to be vindicated. Not a good strategy.
I don’t think there will ever be a time when we are completely out of the woods. If history is any guide, more uncertainty is to follow. The term “climbing the wall of worry” seems as appropriate now as it was in many other times in history. And based upon the frequency of corrections in the markets, we ignore the risks at our own peril.
We will continue our daily monitoring of all strategies and repeat the process of exiting the market as frequently as necessary to help avoid major losses. There are definitely times when it is what you “don’t lose” as opposed to what you may have made that can make the most difference. If we don’t take this approach, we could end up like many other investors who ride the ups and downs and ultimately accomplish very little over the years.
It is always important to talk about risk management, but it is equally important that the risk management you employ has the potential to deliver respectable performance.
Thank you for you continued confidence. If you have any questions, please don’t hesitate to get in touch with us.
Disclaimer: This article has been prepared for general information only. It does not account for the specific investment objectives and financial situation of any person. Investors should seek professional advice regarding the appropriateness of investing as discussed or recommended in this article and should recognize that statements regarding future prospects may not be realized.
The information presented has been compiled from sources believed to be reliable but no guarantee is made as to it accuracy, completeness or correctness. All opinions and estimates contained in this report are provided in good faith and are subject to change without notice.