March 9, 2020: Risk And Reward

Mar 10, 2020 | 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.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Wednesday April 1, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month. 

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.

Risk And Reward

Latest market behavior has been anything but calm, to say the least. Actually, for anyone who listens to news, it’s downright scary: consecutive and almost non-stop big daily loss for the past week and there is no sign of abating. Let’s first review some background information.

Twin evils for the economy

First, a word of clarification: common coronavirus have existed in human for a while in a flu (see CDC), the ‘novel’ or Covid-19 is a different breed of virus. We have seen many media reports (and even some officials) have confused with this new virus with the old ones. So be careful on reading those news.

The current virus outbreak is unfolding in a rapid speed, just as described in our previous newsletter. The continuing spread will eventually force local and federal governments to adopt more prevention measures that in turn affect both financial markets (evidently) and economy (later). This is what had caused big stock market loss last week.

Unfortunately, during the weekend, markets got another huge shock from energy market: because of the fallout of oil country (OPEC+) meeting, oil price dropped about 30% in one day. This has a big implication on economy. The chain effects of lower oil price can be summarized as follows:

  1. Low oil prices cause trouble for many energy companies (especially US companies that have sizable exposure on shale fracking). It’s reported that for many of these US shale business to be profitable, oil price needs to be at least $40 to $50 a barrel. Now it’s $30-ish. Even for many that have no shale oil exposure, the current oil price will be a big blow to their businesses.
  2. These will cause trouble to energy companies’ debt. Specifically, energy companies’ high yield bonds are about 11% of the US high yield bonds. Many of these will be facing default in the coming months. Furthermore, another 11% or so US investment grade corporate bonds are in the energy sector. They are in danger of being downgraded to junk (high yield) category if low oil price persists. We will not go into details on this and refer interesting readers to an excellent Financial Times article.
  3. The energy sector trouble (bankruptcies, layoff etc.) will in turn affect general economy. Though lower oil price will also likely boost consumption and cut down consumer cost, this is probably not enough to offset the negative impact. In the most optimistic case, the disruption will persist for a while.

The massive investment grade bond downgrade has been warned by DoubleLine’s Gundlach for the past year now. He has repetitively singled out this as the major concern to cause an economic recession. Now this low oil price might finally be a catalyst to cause it.

What’s worse, coupled with the weak demand caused by Covid-19 disruption in China and the rest of the world,  weak oil price will likely to stay for a while. The economy seems to be in a perfect storm caused by the twin evils.

Risk and reward

In this troubling time, we want to look at one of our favorite topics over the years: risk and reward.

Many long time readers might have been familiar with our long held belief: one shouldn’t need to take excessive risk to get a reasonable return. In fact, MyPlanIQ is built just on this belief. For example, the newsletter February 24, 2020: Long Term Stock Valuation Based Investment Strategies published two weeks described some of long term strategies that showed some very competitive returns with much low risk. We concluded there

These portfolios continue to defy popular simple claims. They also show that there is a path for a ‘real’ (value) index fund investor: you don’t need to take excessive risk to outperform in a long term. This is especially compelling considering right now, stock valuations are at historically high levels. This also fits well to an ultra conservative income investor (retirees, for example).

Let’s review our current situation (before last week and now):

  • Risk: extremely high stock valuation that has usually exhibited some violent big loss when some black swan style events occur. Historically it’s very common to see stocks to lose 30% or more at one time from a previous bull market peak.
  • Reward: long term returns are very low: for example, Hussman showed the following chart and claimed that his model shows that even at current level, S&P 500 will have 0% annualized return for the next 10 years. Gundlach said he doesn’t expect to see the current high again in his professional life (10 years?). Regardlessly, numerous long term stock valuation metrics also indicate there will be very low return in the coming decade.

Popular financial media and even so called reputable education often claim that bigger risk, bigger returns and lower risk, lower returns. Investors should take such a claim in a grain of salt. In a strict sense, when you only work on a buy and hold asset allocation model, such a claim makes sense. However, this ignores some other ways investors can pursue: sound tactical strategies like a systematic long term timing on a good stock index such as S&P500; instead of investing in ‘cash’, investors can invest in an intermediate term bond index fund to boost returns; or even better, investors can invest in a tactical bond fund portfolio such as those listed on our Fixed Income Investors page to enhance returns and reduce risk further (see previous newsletter on some more discussions on this).

The point here is that risk and reward is not a fixed concept. There are several dimensions that have been ignored or simplified by many. As always, a little more in-depth understanding often reveals the fallacies of popular claims.

Market overview

What has been happening in the financial markets so far is by far the most volatile and serious since 2008-2009. During the time of such a panic, investors should calm down and review their investments objectively. We offer the following:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Finally, as markets are getting more and more reasonably priced (or cheap — we are not there yet, not even close), there will be good opportunities to take more ‘risky’ exposure  in stocks (in fact, a good diversified stock index fund like S&P 500 becomes less risky and even safe when markets are cheap enough). So in a sense, the current market loss is actually the beginning of a good investment opportunity. This is what a good investment strategy is all about.

For more detailed current market trends, please refer to 360° Market Overview.

In terms of investments, even after the recent retreat, U.S. stock valuation is still at a historically high level and a bigger correction is still waiting to happen. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future.

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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