Investment strategy for a down market

Equity mutual fund managers sense a high risk in the stock market and are increasing their cash reserves. But the amount of cash they hold is restricted by the fund’s prospectus. However, notes The MoneyLetter columnist Ken Norquay, we are not restricted by their rules. We can hold 100 per cent of our portfolio in cash reserves.

Time to sell? Will Rogers observed: “Even if you’re on the right track, you’ll get run over if you just sit there.”

We often look toward the unfolding of the New Year with great optimism. But, what if all our hopes and wishes do not come true? Murphy’s Law tells us: ‘Anything that can go wrong, will go wrong.’ Just to be different this year, let’s let our imaginations run amok with pessimism. What can go wrong?

2019 will be an election year for Canada. What if our favourite party loses the election and the other party is elected? 2019 could see a continuation of America’s trade wars. What if worse comes to worst between Canada’s two biggest trading partners, China and the USA?

In 2017-18, Canadian house prices stopped going up. What if Canadian house prices collapse in 2019 as they did in the USA and Europe during the banking crisis of 2008-10?

In 2018 the Canadian and US stock markets peaked and started to go down. What if the down trend continues through 2019?

What if this, and what if that. Our imaginations know no bounds. But, unfortunately, all the items on my Murphy’s Law list could come true. Rather than be optimistic or pessimistic, let’s be realistic.

Use alternative investments in a down market

Realistically, it’s not our job to predict the future. As investors, it’s our job to earn a respectable return on our investments. In my stock market book, Beyond the Bull, I argue that investing is like waging war: there’s offence and there’s defence. I advise people to go on the offensive when the stock market is going up and defensive when it’s going down. By now, it should be clear that the stock market is going down. It’s time for defence.

Defending a portfolio in a down-trending stock market means selling some or all of your stocks and equity mutual funds. We have discussed this many times in past articles. But, in keeping with our theme of thinking differently this year, let’s think about bear market offence instead of defence. How can we take advantage of this down trending stock market? How can we make money when the market goes down?

In the last century, investing in stocks, bonds and mutual funds was easy, but investing in other economic trends was a much more speculative venture. The futures market is a good example of a high-risk way to invest in commodities or currencies.

But modern markets allow us to invest in non-equity securities with no more risk than buying a stock. Exchange Traded Funds (ETFs) offer ordinary investors a lower risk way to participate in price trends of precious metals, the energy complex, foreign markets, currencies or bonds.

So, for example, this column covers precious metals, interest rates, energy and Canadian and US currency price trends. There are ETFs that allow ordinary investors to participate in these trends without the high leverage of the futures markets.

It is beyond the scope of this column to examine the details of specific ETFs and their suitability for your portfolio. However, we need to be aware that there are many low-risk ways to invest when the stock market is going down. Thinking outside the box would be wise for the next year or two. Here, ‘the box’ refers to the stock market.

What’s goin’ on?

Let us review the trends of a variety of financial markets, not from Murphy’s famous point of view of what can go wrong, but realistically: What IS going on?

US stock market: December’s sharp decline to a new low confirmed that the long term trend is down. Bear markets are characterized by volatile jolts down and explosive bounces back up. That volatility reflects the emotions of investors. Those who continue to hold stocks during this bear market, should expect their emotions to increase as the inevitable losses unfold.

The Canadian stock market is also trending down. The main differences between the Toronto and New York markets are: (1) The Canadian market did not sky-rocket up after Mr. Trump’s election, as did the US market, and (2) Canadian energy stocks started their own separate down trend in June 2014, when oil prices peaked. Because the energy sector is so significant in Canada, the TSX Composite did not display the speculative excess that the US market showed.

Interest rates are in an uptrend

US long-term interest rates and the bond market: The long-term trend of US interest rates is up. The US bond market just completed a strong 9-week rally. As the stock market dropped last month, the bond market went straight up. It’s as if American pension fund managers were selling stocks and reinvesting in bonds. However, the bond market’s rally occurred well within the statistical context of its long-term down trend. US interest rates remain in a long-term up trend.

The Canadian bond market is in lock step with US bonds. Canadian interest rates remain in an up trend, in spite of the recent 9-week bond market rally.

The US Dollar vs. ‘the basket’ of non-US currencies has been stable and trendless since 2015.

Loonie is rising; gold and energy drifting

Canadian Dollar vs. US Dollar. The loonie’s long-term up trend is still intact and the short-term down trend seems to be ending.

Gold continues to drift sideways. A sluggish short-term up trend has given rise to a short term up trend in Canadian gold mining stocks, even as the broad markets deteriorated. This same phenomenon occurred in the bear market of 2008-9: as the broad US stock market started down, gold stocks became stronger. Consider gold mining stocks a short-term speculative opportunity for now.

Energy: We are adjusting our opinion of long-term energy prices from up to neutral. Since October 2018, oil prices declined dramatically ending the long term up trend that began in February 2016.

Those who think that the stock market is the only game in town have a big problem. The trend is down. The risk is high.

No investments in long-term up trend

In addition, those whose investment horizons include bonds and non-equity ETFs, also have problems. There is a bear market in bonds. No easy money here. Gold and oil prices are in sideways trading ranges: the long-term trend is neutral. No easy money there. The US dollar is in a sideways trading range too. Where is that elusive up trend in which we’d all love to invest?

We appear to have discovered yet another aspect of Murphy’s Law; another investment problem that could ‘go wrong’. It’s a strategic problem: What should we do when there are no low-risk up trends?

For clarity: Our philosophy is to invest in securities in long-term up trends and sell them when the trend turns down. And, right now, it appears there are no conservative investments in long-term up trends.

For further clarity: long-term investing is different from short-term trading. This article addresses the needs of long-term investors whose overall strategy is: ‘Buy Low, Sell High’. Short-term traders also like to buy low and sell high, but their time horizon is shorter and their risk tolerance is higher.

‘Not losing’ is a good investment strategy

Question: Is it a valid investment strategy for a long-term investor to not invest at all when risk is high and opportunity is low?

From the point of view of today’s mutual fund sales culture, this strategy is not a valid strategy. Modern ‘buy-and-hold’ enthusiasts advise the average investor to ride out the down trends of the stock market.

However, for investors who are even the slightest cut above average, ‘not losing’ is a correct investment strategy. That’s why mutual fund managers change their ‘cash reserve as a percentage of total investments’ when their perception of risk changes. For example, right now, many portfolio managers sense an abnormally high risk in the stock market and are increasing their ‘percentage of cash reserves’ to defend against this risk.

That’s what mutual fund unit holders pay them to do. It’s their collective selling that caused the huge decline in the stock market in December. However, the percentage of total investments they are allowed to hold in cash is restricted by the mutual fund’s prospectus. Of course, all equity mutual funds must always hold a high percentage in equities.

However, we are not restricted by their rules. As private investors, we can hold 100 per cent of our portfolios in cash reserves. They can’t.

Ken Norquay, Chartered Market Technician (CMT), is the author of the book Beyond the Bull, which discusses the impact of your personality on your long-term investments: behavioural finance.

This is an edited version of an article that was originally published for subscribers in the January 2019/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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