August 24, 2015: Market Rout And Your Portfolios

Aug 25, 2015 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Monday, August 31, 2015. You can also find the re-balance calendar for 2014 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Market Rout And Your Portfolios

In the midst of the current stock market rout, how to respond or cope with it is on many investors’ mind. For many who have experienced several market shocks such as those in 2008-2009, 2000-2002, 1997 Asia financial crisis or even 1987 stock market crash, the current one does not seem to be particularly stressful. Been there, done that. However, regardless of whether you have such experience or not, it is still a fast and painful one. Welcome to the fast paced financial marketplace that buys and sells paper based financial certificates in the blink of an eye. 

The run-of-the-mill market correction

Let’s first review what have happened. First, a year to date S&P 500 index chart: 

The current market action does look like a big and fast one since last Monday. In fact, it has been a non stop 6 day drop that took S&P 500 from 2102 all the way down to 1893, a 10% drop . However, looking more closely, one can see that the current ‘correction’ is merely an 11% drop from S&P 500’s all time high 2130 on May 21, 2015. When compared with other numerous fast air pocket pops such as the one day  8% drop on Sept. 29, 2008, this one is just something one should expect to see from stock markets every now and then. So far, it is just a run-of-the-mill correction. 

Market corrections and bear markets

 Some interesting terminologies and stats: 

  • A market correction is defined in popular media as an index decline of more than 10%. So including today’s market drop, the current one qualifies as a market correction. 
  • A bear market is commonly defined as a 20% or more decline of a market index. To reach a bear market, S&P 500 will need to drop to 1700 level.  At the moment, the Chinese stock market and many others are in the bear market territory: 

Global Stocks Trend

08/24/2015

Description Symbol 1 Week 4 Weeks 13 Weeks 26 Weeks 52 Weeks Trend Score
Belgium EWK -6.53% -8.28% -6.93% -3.94% -1.0% -5.34%
Switzerland EWL -6.28% -5.35% -9.36% -3.15% -3.84% -5.6%
The Netherlands EWN -6.91% -8.62% -10.39% -5.18% -1.09% -6.44%
Italy EWI -9.48% -6.05% -8.88% -3.37% -9.5% -7.46%
Austria EWO -6.03% -5.51% -9.83% -5.18% -12.37% -7.78%
France EWQ -8.34% -6.94% -9.97% -6.33% -8.6% -8.04%
Japan EWJ -11.2% -9.45% -12.96% -5.72% -2.79% -8.43%
Germany EWG -7.84% -8.23% -13.6% -11.37% -10.43% -10.3%
Spain EWP -7.28% -8.84% -11.54% -8.54% -18.9% -11.02%
United Kingdom EWU -9.47% -7.86% -14.51% -11.59% -16.39% -11.96%
India INP -11.11% -11.22% -13.0% -17.79% -13.21% -13.27%
South Africa EZA -7.27% -11.46% -20.49% -20.88% -21.4% -16.3%
Mexico EWW -10.08% -9.96% -16.89% -16.43% -30.4% -16.75%
Canada EWC -9.83% -8.48% -19.86% -17.63% -28.74% -16.91%
Hong Kong EWH -14.27% -15.89% -24.55% -14.9% -17.13% -17.35%
Singapore EWS -8.78% -17.17% -23.13% -19.85% -24.77% -18.74%
South Korea EWY -7.8% -12.2% -25.34% -20.18% -31.48% -19.4%
China FXI -14.79% -14.7% -32.98% -19.93% -15.54% -19.59%
Taiwan EWT -11.58% -16.79% -27.07% -23.92% -25.17% -20.91%
Australia EWA -13.0% -14.45% -21.86% -24.29% -32.06% -21.13%
Russia RSX -11.28% -12.89% -28.62% -15.25% -40.99% -21.81%
Malaysia EWM -6.36% -20.29% -28.6% -28.49% -39.56% -24.66%
Brazil EWZ -8.22% -14.4% -28.48% -29.61% -51.59% -26.46%

In the above table, the highlighted half of the table includes all those country stocks that have been in a bear market while those in the first half are more or less in a correction mode. Globally, we are for sure in the middle of a storm. 

  • A bear market action normally behaves in several phases: phase 1, fast “air-pocket” correction; phase 2: some fast and strong rebound; phase 3: more decline to a new low; phase 2 and phase 3 can be repeated multiple times. So if the current market rout indeed turns into a bear market, one will see some fast and sometimes even very strong rebound (phase 2) and followed by another decline.  Simply put, if this is the beginning of a bear market, we will still have some more way to go. 

So what to do in the current environment? The short answer is to stay on course, if you have already had a well defined investment plan. For those who would like to ponder further, we offer the following discussions on our two asset allocation strategies: Strategic Asset Allocation (SAA) and Tactical Asset Allocation(TAA)

What to do: Strategic Allocation

Again, we remind readers that a strategic allocation based portfolio is a long term portfolio that buys and holds assets for a long time. It does periodical rebalance to adjust the portfolio’s allocations.  Anyone investing in such a portfolio needs to understand that many assets (stocks, REITs, commodities (if any)) will need to be prepared for double digit bear market losses. This is important because it will give you a reasonable expectation that prepares you for a loss that can be hard to face and that needs a strong stomach to get over with. 

Here is the table of the major maximum drawdown or peak to trough loss of several major asset classes since 2000: 

Maximum drawdown since 2000: 

Asset Classes Maximum Drawdown (Loss)
US Stocks VFINX -55%
Intl Stocks VGTSX  -61%
Emeging market stocks VEIEX  -66%
REIT VGSIX  -73%
Commodities DBC  -52%
US Bonds VBMFX  -5%
US High Yield Bonds VWEHX  -30%

For a moderate risk portfolio with 60% stocks and 40% bonds, it still experiences a 20-30% loss during a severe bear market. For example, the maximum drowdown of VBINX (Vanguard Balanced Index Inv), an index with 60% US stocks and 40% US bonds has a maximum drawdown 36% in the 2008-2009 crisis. 

What we can say about an SAA based portfolio:

  • However, investors should have a realistic notion about long term in this type of portfolios: it can be as long as 10 years or even longer to achieve a reasonable return. For example, from October 1, 2000 when stock market peaked to October 1, 2007, another market peak, Vanguard balanced fund index VBINX had an annual return of 4.8% or from September 1, 2002, a market trough to February 1, 2009, another market trough, VBINX returned 3% annually. These returns are very much mostly from the bonds it held. 
  • The main defense in these portfolios is to properly allocate between stocks (risky assets) and bonds. At the moment, it is still not too late to make a proper adjustment. If your portfolio has overweight on stocks, you might want to re-evaluate your risk tolerance and make adjustment accordingly. 
  • Before the current market correction, US stocks was highly overvalued. It is expected to return 0-2% annually in the next 10 years, depending on how you calculate it. So be prepared for a low return. 
  • However, for any new money or new investors, the current correction is a welcome one: the valuation is more reasonable now (although it is still high). If a bear market indeed materializes, investing at a lower level can be very rewarding. 
  • Finally, again, remember the first point: stocks will always deliver positive returns in a long term. So one should not be panic and should stay on course!

What to do: Tactical Allocation

As we stated in July 22, 2013: Tactical Asset Allocation: The Good, The Bad And The Ugly, the TAA strategy relies on trial and error to latch on secular asset trends. The strategy pays the price of several smaller guessing errors to avoid big loss and capture large secular up trends. 

The strategy has not done as well as SAA since 2009. This is expected. Even though it has made many investors uncomfortable, we believe it has met with our expectation: a strategy to deliver a reasonable return during a bull market and avoid big loss in a bear market. If the current correction turns into a big bear market, it will hopefully exit from all risky assets before that happens. At the moment, our TAA has exited from all but US stocks, allocating only half of target risk allocation to it. 

We offer the following observations on this strategy:

  • Be prepared to still pay a price to be error out. This is uncomfortable but as we stated, it is the price the investors (of this strategy) should be willing to pay. 
  • We re-iterate that such a strategy can still not avoid a huge sudden short term loss such as the one in 1987 crash. See October 28, 2013: What Can We Learn From The 1987 Stock Market Crash?
Finally, we would like to emphasize that as markets are becoming more reasonably priced (i.e. cheaper or lower market index), it will become less risky to invest. Though we are not there yet, but instead, we should be more optimistic instead of pessimistic as every market decline goes by.  

Market Overview

There are many factors that might have contributed to the current decline: the Chinese stock market rout and its deteriorating economy, the possible currency war, the upcoming Federal Reserve’s interest rate hike; the uneven economic indicators, a nervous high yield debt market (high yield bonds have been weak for a while now),  and the energy market (crude oil especially) chaos. Our guess is that in a highly overvalued market and a fragile global economy, small factors can trigger some significant events. Fortunately, we do not need to pinpoint the exact causes and  rely on solving such intractable problems to construct a risk managed portfolio. 

For more detailed asset trend scores, please refer to 360° Market Overview. 

We would like to remind our readers that markets are more precarious now than other times in the last 5 years. It is a good time and imperative to adjust to a risk level you are comfortable with right now.  However, recognizing our deficiency to predict the markets, we will stay on course. 

We again copy our position statements (from previous newsletters): 

Our position has not changed: We still maintain our cautious attitude to the recent stock market strength. Again, we have not seen any meaningful or substantial structural change in the U.S., European and emerging market economies. However, we will let markets sort this out and will try to take advantage over its irrational behavior if it is possible. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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