How to Profitably Protect Your Portfolio for the Next Bear Market
Stretched to Breaking Point
The first thing you should know about me is this: I am not a doomsday bear.
I know a lot of people in my profession have done extremely well for themselves selling the end of the world. They pitch a tale about the impending collapse of the global financial system, or the total breakdown of confidence in the entire fiat (paper) money system.
These scenarios are not a “base case” for me at all.
I’m realistic. I’ve been through more than my fair share of financial crises. From the property market bubble here in Hong Kong in the early 1980’s, to the October ’87 crash, to the Asian Financial Crisis of the late 1990’s and so on.
Panic does nobody any good whatsoever. And believe me, it will do absolutely nothing for your portfolio either.
But that doesn’t mean you shouldn’t be cognizant of risks, and I believe there are risks ahead.
As I mentioned on the previous page, economic cycles are inevitable as night and day. Yet few seem to prepare for them.
As John Hussman recently observed “market peaks are not an event, but a process”.
I believe we are entering that “process” right now.
Since March of 2009, U.S. equity markets have enjoyed one of the longest bull runs in living memory, rising over 200%.
I guess we can largely thank the Fed in all its money-printing glory in part for that.
I think that line of thinking is dangerous for a few reasons.
Firstly, the absolute earnings multiple isn’t the only factor to consider. For example, in late 2007 the S&P traded at around 16 times earnings… and in the subsequent 18 months fell by nearly 60%!
Secondly, the huge quantity of stock buybacks has skewed this ratio. Companies are buying back more of their stock than they did prior to the GFC. When you buyback your own stock, you reduce the number of shares outstanding. The same amount of earnings are distributed amongst fewer shares, and hey presto, your earnings per share goes up!
Thirdly, I want to look at price-earnings on a longer timeline. As I mentioned, economies move in cycles, so we should be at least taking that into account.
The Shiller price-earnings ratio, also known as the Cyclically-Adjusted Price-Earnings ratio (or CAPE) looks at stock prices against average earnings over a 10 year period, giving us a much better representation of the business cycle (Figure 2).
So the CAPE doesn’t look particularly promising… how about another measure?
Warren Buffet has described this as “probably the best single measure of where valuations stand at any given moment”.
He’s talking about the ratio of the market value of equities to GDP (Figure 3).
But the simple reality is that there is no single metric that tells us everything we need to know. Otherwise investing would be pretty easy!
There is one other interesting indicator that I came across recently. It’s not a valuation indicator per se, it’s a “recession indicator” put together by the folks at GaveKal (Figure 4).
I always take these kind of indicators with a pinch of salt. Like I said, there is no one-size-fits all metric that tells you everything. But GaveKal is a highly respected research firm founded by and run by world class analysts.
How’s it gonna happen?
I get asked this all the time: “what’s going to trigger the next downturn?”
Here’s the thing: I have absolutely no idea whatsoever what the catalyst will be. And frankly I couldn’t care less because it’s irrelevant!
When you take out insurance on your house, you don’t only get covered for the risk of a fire, you take out protection against everything… earthquakes, storms, wind, fire, flooding… a tree falling through your roof.
It’s the same with our portfolio. If the market corrects 25% in 3 months, do I care what caused it? Or do I just want the best protection against the 25% decline?
The only thing I know is that the catalyst will be obvious… in retrospect!
So… What do we do?
Let’s say you agree with my line of thinking. Let’s assume you are of the opinion that it’s high time to start thinking about de-risking your portfolio and putting in some defensive plays…
How do you go about it?
Your first idea might be to unload cyclical stocks (i.e. those who’s fortunes are more closely tied to economic cycles) and start buying defensive stocks.
Great! It would be a good start. Except for one thing: some traditionally defensive stocks haven’t provided any protection at all against the down cycles.
Let me explain.
There are 4 main types of defensive stocks according to common wisdom:
Healthcare – life goes on regardless of annual GDP figures. You still need to see a doctor when you’re sick.
Utilities – lights, gas, powering your home, flushing the toilet… again, these are basic necessities that won’t change much in a recession.
Consumer Staples – from shampoo to toothpaste, toilet paper to tobacco, consumers continue to buy these everyday items regardless.
Telecoms – mobile phones and internet connections.
Well, we did some analysis on how these sectors have actually performed during the downturns. And the results were quite surprising.
We looked back at the two most recent big corrections in the U.S. equity markets, namely the 2000 Dotcom Bubble, and the 2007 Global Financial Crisis.
We then indexed the performance of these defensive subsectors against the S&P500 index.
The results speak for themselves…
The first observation here is that during the Dotcom bubble, both telecommunications and utilities actually underperformed the broader index on a 3 year time horizon (Figure 5).
Moving on to the GFC, you can see there was a much higher correlated reaction across the defensive sectors (Figure 6). Although again, both utilities and telecommunications underperformed the broader index on a subsequent 3 year horizon.
And in the wake of the GFC, the sector was never down more than 30% and recovered to it’s pre-crisis level in less than 3 years.
Of course, we need to take into account the valuation starting points.
For example, at the 2000 peak Consumer Staples traded at 20 times trailing earnings versus the S&P500 at 28 times. That would explain the significant subsequent outperformance because Staples were already considerably cheaper going into the downturn.
BUT, Consumer Staples weren’t significantly higher than the broader market at the 2007 peak. The sector was at 19 times earnings versus 17 for the S&P500.
And right now, the sector is trading at 20.5 times trailing earnings versus 18.85 for the S&P500.
I recommend switching some of your U.S. equity allocation into consumer staples.
You can do this easily and cost effectively using the Consumer Staples Select Sector SPDR Fund (XLP US).
This is a large and liquid ETF, and charges an expense ratio of just 0.15%.
It holds a range of cosmetic and personal care stocks, along with soft drinks, tobacco and food etc… with big names like Procter & Gamble, Coca-Cola, Walgreens and Philip Morris.
As a bonus it offers a higher yield than the S&P500 index (2.5% versus 1.95%), and has historically exhibited lower volatility than the broader market.
A key point here is also to realize that despite making this defensive allocation, we can still enjoy plenty of market upside. If this rally continues for another 6 to 12 months, we want to be a part of it! And this ETF lets us do just that.
ACTION: Buy the Consumer Staples Select Sector SPDR Fund (XLP US) with a 25% trailing stop loss.
I also recommend you diversify into some broader international consumer staples as well. Again, you can do this easily with the SPDR S&P International Consumer Staples ETF (IPS US).
This is a basket of top quality consumer staples companies. And that’s the key word we’re looking for… ‘quality’.
Names like Nestle, British American Tobacco, Unilever, Diageo and so on.
These are top blue chips that let us sleep well at night. They are relentlessly reliable dividend payers. Only 2 of the top 10 holdings in this ETF lowered their dividend during the Global Financial, and one was only a marginal decline.
ACTION: Buy the SPDR S&P International Consumer Staples Sector ETF (IPS US) with a 25% trailing stop loss.
My next recommendation isn’t buying anything at all. It’s selling.
I’ll get straight to the point: I don’t believe you should be holding any high yield bonds in your portfolio right now.
Let’s look at the iShares IBOXX High Yield Corporate Bond ETF (HYG US). It’s the largest and most liquid high yield bond ETF in the U.S. with assets under management (AUM) of nearly US$16 billion.
First off, it’s not particularly cheap with an expense ratio of 0.50% annually.
Secondly, let me bring in this chart from Standard & Poors showing the historical default rates going back to 1981 (See Figure 7 – next page).
It exhibits a clear historical pattern which brings us back to what I mentioned at the beginning of this report… cycles.
The third point here is let’s actually just take a look at what’s inside our high yield ETF. Below we show the high yield ETF bond weightings and their respective credit weightings. We also include the description that S&P gives for each rating to give you a sense of just how creditworthy this paper is…
|S&P Rating||S&P Rating Description||ETF Allocation|
|BB||Less vulnerable to nonpayment than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could leat to the obligor’s inadequate capacity to meet its financial commitment on the obligation.||48.81%|
|B||More vulnerable to nonpayment than obligations rated ‘BB’, but the obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation.||40.70%|
|CCC||Currently vulnerable to nonpayment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. In the event of adverse business, financial, or economic conditions, the obligor is not likely to have the capacity to meet its financial commitment on the obligation.||8.58%|
Do we really want to hold much, if any, exposure to this kind of credit risk at this stage in the credit cycle? I don’t think so.
The final point I want to bring up is that if we take 2 very simplistic assumptions about how the next 1-3 years pan out, neither of them is good for high yield.
Let’s start with the bull scenario. The economy does great, and interest rates start to normalise.
Well, you’re a) holding bonds which will lose value as interest rates rise. And b) you’re going to start finding that a lot of marginal companies who’ve been able to survive by financing themselves at artificially low rates don’t have business models that support a significantly higher cost of funding!
And the bear scenario? We slide into a recession, and naturally the business cycle normalises and the default rate tends back towards (and above) its historical average.
This means principal loss in your high yield portfolio. Period.
ACTION: Reduce ALL Exposure to High Yield Bonds… sometimes it’s called ‘Junk’ for a reason!
The next thing you should do? Simple. Increase your allocation to cash.
I know, I know. That’s ‘boring’. Cash doesn’t earn you anything. And inflation eats away at it.
That’s all true, but let me tell you something. I know you’ve heard it before but I’ll say it again… cash is king.
Why? Because there’s very little value on the table in equity markets right now. Stocks are simply not cheap. But they will become cheap again, and when they do, guess what you’ll want to have lots of? Cash.
I am clearly not saying you should hold nothing but cash as a long term investment. We all know that over time cash becomes worth less and less as inflation eats away at it.
I’ve recommended staying long equities (selectively) so we can maintain our upside exposure.
However, if you’re holding positions that you deem speculative. Or if you’re long a lot of cyclical stocks, then I think it’s worthwhile trimming them down and moving to cash.
Your allocation to cash should be dependent on your financial circumstances, but anywhere from 10-50% is perfectly acceptable in my opinion.
Right now, my portfolio is approximately 37% cash. It’s predominantly U.S. dollars. But I also recommend some British Sterling as well.
ACTION: Start increasing your allocation to CASH.
There are 2 further ways you can prepare your portfolio. I’ll talk about them separately but they are both generally adopted and recognized techniques for reducing your portfolio risk.
I can guarantee you’ll be familiar with these techniques. But I also know that most individual investors don’t utilize them properly.
The first strategy is diversification.
This doesn’t guarantee against loss, but rather proper diversification of your portfolio will reduce both volatility and downside.
I could write an entire essay about the financial theory underlying diversification and the mathematics, but the common consensus for your equity portfolio is that you reach optimum diversification with approximately 20 stocks.
And these positions should be spread across different industries, sectors, countries and company sizes. Our goal here is to reduce the correlation of the stocks we hold. Clearly, holding 20 mining stocks isn’t going to do much for reducing your equity risk!
After ensuring you have a sensible degree of diversification within your equity portfolio, take a step back and assess your overall portfolio.
Typically the 3 core assets that investors look at are cash, equities and bonds. But you can more broadly diversify your portfolio simply by adding exposure to additional asset classes, particularly ones with a low beta to the broader market. It could be Real Estate Trusts (REITs), commodities (MLPs), Alternatives (Private Equity, VC, and Hedge Funds)… even Inflation (TIPS).
I’m not suggesting you go out and start throwing additional asset classes into your portfolio. I’m just reminding investors that the investment horizon today is wide. And diversifying the asset classes in your portfolio can help reduce risk when done properly.
For 90%+ of investors however, I believe that the initial concentration should be on their bond, stock and cash portfolio mix.
The second strategy is hedging.
This is a trickier hurdle for most individual investors to overcome.
There are 2 primary means of hedging your equity portfolio: buying put options, or short selling.
Of the 2, outright short selling is the easier, both to execute and to understand.
Most brokerages will let you short sell stocks and ETFs with the click of a button.
Buying put options is more complicated. It’s not hard to learn but I would only advise that people who genuinely understand how option pricing actually works involve themselves in buying (and especially selling) options.
[The biggest benefit of buying put options is the absolute asymmetry of risk. By that I mean you have huge upside potential, and a fully predetermined downside i.e. the option premium you pay.]
Shorting stocks is purely a matter of buying some insurance on your portfolio. It’s not a question of trying to time the market. It’s purely about adding some downside protection by shorting stocks you think won’t perform well.
The basic rules I recommend following when shorting stocks are these:
- Don’t short illiquid or thinly-traded stocks. If you can’t take profits or cut losses quickly then you’re in trouble.
- Avoid shorting stocks that have a high level of short interest*. This will leave you vulnerable to a short squeeze** when other investors rush to ‘cover’ their short interest by rapidly buying up the stock again, pushing the price up. It also suggests that negative news is already priced in.
- Target both a weak company and a weak sector. Weak companies in a strongly performing sector can still go up… ‘a rising tide lifts all boats’ as they say.
- Have an exit strategy. We use trailing stop-losses on our long positions, so please do the same with your shorts. Short positions can potentially lose multiples of your initial principal so if you are short a stock and it breaks your stop loss level, then buy the stock back and cover. No questions asked.
*Short interest is the percentage of a company’s float that is currently held short.
**A Short Squeeze is a situation in which a market event can cause the stock to jump higher, which forces investors who are short the stock to buy it and ‘cover’, which forces the stock price further up triggering more shorts to buy. The Volkswagen short squeeze in October of 2008 is a prime example of just how vicious this scenario can be.
On balance, shorting can feel daunting. Even for experienced investors. We won’t be making specific short recommendations in this free report, but I strongly suggest that now is the perfect time to start getting comfortable with the concept. And remember, our goal here isn’t to make money. Nobody buys insurance to make money. They buy it to protect themselves when bad things happen.
ACTION: Give your portfolio a full health check-up if you haven’t already and make sure both your equity positions and your portfolio as a whole are adequately diversified. In addition, take some time to understand how shorting a stock works and the considerations you need to take into account.
My final recommendation is perhaps somewhat strange. It’s an asset class that is by all accounts nearing the culmination of a 3 decade bull run. Many would argue it’s a gigantic bubble… an accident waiting to happen.
I’m talking about the U.S. treasury market. More specifically, the market for long dated U.S. treasuries.
U.S. treasury yields have been an almighty tear. Over the past couple of decades the Barclays U.S. Treasury 20+ Year Total Return Index has returned roughly 18% less than the S&P500 on an annualized basis but with more than a third less volatility.
I think all investors should have some exposure to this paper for a few reasons…
Firstly, it’s traditionally uncorrelated with broader equity markets. Whilst correlation will vary over time, the average annual correlation between bonds and the S&P500 over the past 20+ years has been just 0.01. Remember, a correlation of 0.00 implies the asset classes have no correlation with one another whatsoever. And a correlation of 1.00 means perfect correlation between asset classes.
The second reason is that long-dated treasuries are part of your portfolio insurance package.
Because regardless of what you think about the U.S. government, fed policy, the pace of future interest rate rises, or the size of public debt, treasuries are still the safe haven asset.
Any talk of the impending demise of the dollar as the world’s reserve currency is thoroughly premature.
When the U.S. slips into recession and equity markets correct, treasuries will be a beneficiary in nearly every scenario I can see.
Note: It’s very hard to visualize a scenario in today’s environment whereby we see a massive simultaneous bear market in both treasuries and equities. A large and unexpected rise in inflation and inflation expectations, combined with rapidly rising interest rates is one of the only scenarios that I think would achieve this.
The final reason I want exposure to long dated treasuries in particular is that we get a lot more interest rate bang for our buck.
Let me explain.
Regular bonds all measure their interest rate risk in terms of duration. And longer dated bonds have a higher duration than shorter dated bonds.
Duration is calculated in years and gives you an idea of how much price change you’ll get on your bond for a given change in interest rates.
For example, let’s compare the current 10-year and 30-year U.S. treasuries. The 10-year one has a duration of 8.75. The 30-year bond duration is 19.50.
This simply means that for a 1% fall in the interest rates, we can expect the 10-year bond price to rise by 8.75%, and our 30-year bond price to rise by 19.5%. And vice versa if inter-est rates rise.
Using long dated bonds simply allows us a more leveraged exposure to interest rate risk. We can still maintain a trailing stop on our position, but it means that in terms of risk exposure, we can take a smaller allocation to treasuries and perhaps hold more cash instead.
If interest rates start to drift higher as the Fed eases into a gradual tightening pattern, then we can look at reducing duration by selling out of long dated paper into medium term.
But either way, it’s absolutely CRITICAL that investors understand the duration of their fixed income portfolios.
We gave an example of a 10-year versus 30-year bond duration comparison, but I want to share with you just how big a difference duration makes.
Vanguard is one of the largest and most successful of ETF providers. They, like most other financial product providers these days, make an effort to provide an associated risk scale for each of their products.
They have a simple risk scale numbered 1 through 5, with 1 being the least risky and 5 being the riskiest.
It has US$37 billion of assets under manage-ment. It holds emerging markets stocks… from countries like China, India, South Africa, Brazil, Russia and Mexico.
This is a Level 5 on Vanguard’s risk scale. This makes sense. Emerging market stocks are a risky asset class.
At the other end of the scale, we have the Vanguard Short-Term Government Bond ETF (VGSH US). This holds short-term treasuries only.
This is a Level 1. It doesn’t get less risky than short-term U.S. bonds.
Finally, they have another bond ETF.
It holds nothing but U.S. treasuries. There’s no stocks here… and certainly no emerging markets… and yet its risk level?
Level 5. The highest possible and on par with emerging market stocks.
Why? Because this ETF is called the Vanguard Extended Duration Treasury ETF (EDV US) and it holds nothing but 20 to 30-year zero coupon bonds. And its duration is nearly 25 years…
That should give you an example of just how important understanding interest rate sensitivity is! Vanguard are saying that long-dated zero coupon U.S. treasuries are just as risky as emerging markets stocks!
ACTION: Buy some longer-dated government bonds as a portfolio hedge, but ensure you fully understand and measure the interest rate risk associated with it.
I sincerely hope we’ve given you something to think about.
The bottom line is this report presents some small changes which I believe will put your portfolio in a much stronger position when the current cycle inevitably turns.
I reiterate again, it’s not time to panic! But rest assured global markets remain fragile.
We’ve had a near-uninterrupted bull run for over 6 and a half years now. Long-term valuations look increasingly stretched.
There’s no penalty for being a little early… but being late is expensive.