Know your risk profile

Ordinary investors need to know that these are not ordinary times. It’s time to review your risk tolerance. Ken Norquay asks: Are you satisfied with the profits you have just made?

Ken Norquay says: “It’s time to review your tolerance for risk.”

I knew I’d find one sooner or later! I knew I would find an ordinary investor whose instinct and understanding of the stock market are right on. Most ordinary investors get their investing education from a commission-driven sales person. But Mike didn’t. When he retired, he converted his company pension plan to a locked-in RRSP and followed his fellow retirees’ example. He filled in all the forms and followed everyone else into the world of mutual funds. He didn’t even read the prospectuses. He just went along with the others.

In June, his representative called and told him that the equities portion of his portfolio had gone up so much that it had become risky. In order to continue holding the equities mutual funds he owned, he would have to change his risk tolerance from “risk averse” to “willing to accept market risk”. Not knowing what all this meant, he agreed.

When he found out that I had spent my career in the investment world, had been the president of two brokerage firms and a partner in an investment management firm, he decided to ask me some questions. Why had his mutual funds company rep called him? What’s a risk profile? He had just made $XXX in the past year and was happy with that. He didn’t need to make any more. He just wanted to lock in the profits he had made and continue to draw down his retirement plan each month. What should he do?

I answered his questions

The market has gone crazy since governments started printing money in March 2020. Because the market has gone so high, it has become much riskier than normal. It’s like a bubble waiting to pop. The mutual funds companies know this and are protecting themselves from being sued when the market drops back down to more normal levels. Provincial securities law dictates that mutual funds companies can’t sell their clients investments that pose a higher risk than is suitable for that client. Because the stock market has gone crazy, the reps are calling their clients and asking them to either (a) reduce their holdings of equity mutual funds, or (b) increase their risk tolerance. I translated this mutual fund jargon into ordinary investors’ words: “Sell your stocks. The stock market has become a casino, no longer suitable for risk-averse long-term investors.”
I advised him to call his rep and tell him to change his risk tolerance to “Risk Averse”. The rep will then sell his equity funds and buy bond funds or cash equivalents.

When enough is enough

What impressed me most about my friend Mike was that he realized that he had reached his goal. He never thought his RRSP would be worth so much! And now that it had gone up so very high, he merely wanted to keep what he had made. He felt no need to make even more. He was sincerely worried that he might lose what he had just made. He felt fearful at the top, when ‘the crowd’ was feeling greedy. His instincts were in harmony with stock market reality. How rare!

I was also impressed with the mutual funds company for making all those calls to unsophisticated clients. Most clients (and most reps) don’t understand how stock market risk changes with price. Fortunately, most investment firms are concerned about protecting themselves from being sued when the inevitable market decline comes. By protecting themselves, they are also protecting clients. The problem will come for those over-excited investors who want to make even more profit—those who increase their risk tolerance from “safety first” to “roll those dice”.

My articles normally assess risk from the point of view of market trend, not economic analysis. This time, let’s review our usual financial markets from the point of view of a mutual funds company and their financial analysts.

US Stock Market. The high for the S&P500 Index was 4,545, just before Labour Day. Financial analysts have noticed that its price/earnings ratio is 34, over double its historical average. The US market is twice as expensive as usual right now. In order to restore normalcy, either (a) the S&P500 has to stay the same and the earnings of America’s 500 biggest companies has to double, or (b) earnings have to stay the same and the stock market has to go down. It’s easy to see why Canada’s biggest mutual funds are worried about protecting their firms. For now, the long-term trend of US stocks is UP.

Canadian Stock Market. The all-time high of the TSX Composite was 20,821, reached in early September. BNN Bloomberg reports a price-earnings ratio of only 19.4, not at all over-valued, based on traditional financial analysis. Perhaps today’s prudent mutual fund managers are reacting to the extremely high annual investment return of the TSX composite: 30.6 per cent. The historical average is around 10 per cent. The long-term trend is UP.

US Bond Market. The American bond market peaked in the summer of 2020 (measured by the price of TLT, which is the ETF representing long term US treasury bonds). The long-term trend is down—interest rates are moving up. It was fun to see Chairman Jerome Powell’s September report on the Federal Reserve Board’s COVID crisis policy. Mr. Powell’s job is to inspire economic confidence in America. He reported that he might respond to the economy’s growth by raising interest rates in 2022 rather than wait until 2023. Why was this ‘fun’ for me? Because federal funds interest rates follow the bond market. It’s the bond market that determines interest rates in the USA, not Mr. Powell and his FED. Mr. Powell doesn’t have any choice but to raise short-term interest rates. His money-printing, bond-buying binge stopped working over 14 months ago when the bond market peaked. All he’s doing now is causing inflation. Higher inflation always leads to higher interest rates.

Canadian Bond Market. Canadian bond prices move in lock step with their American counterpart. The long-term trend of Canadian interest rates is UP. As in America, Canada’s central bank is trying to maintain an easy money policy to help our COVID-ridden economy. But, underlying reality has not changed: the pandemic is still a problem and the economy is still a problem. The vaccines haven’t yet stopped COVID from spreading and the monetary printing press hasn’t yet saved the economy.

US Dollar vs. The Basket of Non-US Currencies. The US Dollar has been going nowhere since early 2015. The long-term trend is neutral and the short-term trend has also been neutral for over a year. Currency stability is a blessing in these unpredictable days of pandemic.

Canadian Dollar vs. US Dollar. The long-term trend has been neutral since early 2015; the loonie has traded between about 70 cents and 80 cents US. Currently near the top of that trading range, the short term trend turned down in spring of this year.

Energy Prices. Oil has been in a short-term up trend since the spring 2020 climactic low. That up trend has been very shallow since March 2021. Financial analysts are not complaining about over valuations in oil prices. However, the price of natural gas has run up sharply this past month, to levels not seen since 2008/9. Energy companies have been using profits from these commodities price increases to pay off debt and, in some cases, increase dividend payouts. Portfolio managers find no excessive valuations in oil stocks.

Gold vs. US Dollar. The long-term up-trend of gold began in January 2016, ran up into August of 2020, and is currently in a short term decline. We continue to recommend precious metals ETFs, coins or bullion for investors. Gold and silver mining stocks are more speculative, making for an interesting case for those with good trading discipline.

Look at a 20-year chart of the S&P500 Index

Mutual funds managers have never seen anything like this before. If they reduce equities holdings too soon, more aggressively managed mutual funds’ rates of return will outshine theirs. If they are too aggressive, their clients could lose the stellar profits they just made. They are not sure how to manage their equity portfolios. But their legal advisors are sure. Ordinary investors need to be told that these are not ordinary times. It’s time to review your tolerance for risk. Are you satisfied with the profits you have just made?

Ken Norquay, CMT, is the author of the book Beyond The Bull which discusses the impact of your personality on your long-term investments: behavioural finance. He can be reached at kennorquay@yahoo.ca.

This is an edited version of an article that was originally published for subscribers in the October 2021, First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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