Beware the bear; it’s time to adjust your investment strategy

Limit the risk of your holdings. Adopt an investment strategy that will let you profit from—rather than be victimized by—bear market conditions.

In theory, January is supposed to indicate how the rest of the year will go. The Stock Trader’s Almanac notes that, as a barometer, January has been a pretty good one. Since 1950, it’s missed only eight times. The caveat here is that three of those misses have been in the past six years.

How have things played out in the two most recent Januarys? January of 2014 ended with a loss of 64 points on the S&P 500 composite index. And January of 2015 was essentially no different; the month came to a close with a loss of 66 points.

It’s worth noting that last year’s loss during January did not act as an accurate prediction regarding market losses for the year. Instead, the S&P 500 closed 11 per cent higher in 2014.

So says Keith Richards, portfolio manager at Barrie, Ontario-based ValueTrend Wealth Management, who reminds us that he noted in his last column here in The MoneyLetter that making predictions surrounding market movements becomes increasingly difficult the further out you project. The potential for longer-termed anomalies presenting themselves increases as you go forward in time. This can and will disrupt your analysis in setting your best long term investment strategy.

S&P 500: Signs of turbulence ahead

So it’s easier to predict markets over a shorter period of time. Having said that, I will stick my neck out a bit here and offer some thoughts as to why I believe the markets may experience a fairly significant correction in 2015.

One of the ways that we at ValueTrend have managed to provide our clients with above-average returns with below-average risk has been through selling when markets look overvalued. A “buy-and-hold” approach can often be a more risky long term investment strategy than a disciplined selling strategy. We believe that the stock markets are overdue for a correction, one that will likely occur in the second half of this year. Several pieces of evidence support this opinion:

■ The Shiller inflation-adjusted Price/Earnings ratio is over 26 times trailing earnings—a level that has preceded corrections in the past.

■ The U.S. dollar has become overbought in the face of that country’s role as the sole leader in global economic growth. The train has to stop at some point. The U.S. Federal Reserve has threatened to raise rates. However, we think it may not take such action as aggressively as some observers are suggesting. This may weaken the greenback, given the anticipation of a more aggressive rate policy than may be the reality.

■ Corrections of more than 20 per cent are normal for a healthy stock market. The U.S. markets have not had such a move since the summer of 2011. The five-year bull/bear cycle—and common sense—suggests we are due for a correction.

■ U.S. presidential electoral cycles suggest strength in the first half of a pre-election year (2015 is such a year), followed by a weaker second half.

■ Volatility has increased from the fourth quarter of 2014 into the current year. This can be a sign of a market transition from a trending market to corrective action.

■ Perhaps most importantly: sentiment indicators are SCREAMING: “overbought”. The so-called “dumb money” (the Street’s less-than-gracious term for retail and mutual fund investors) loves this market. Current levels of optimism have historically led into corrections.

■ Finally, although this is not related to the U.S.A., our economy is and will continue to falter in the face of weak oil prices (which will recover, but not to their old highs any time soon). Thus, the Canadian dollar will likely remain weak, and our bond yields will stay low.

How I will limit market risk

At this point, I remain “long” on the stock market—that’s the opposite of shorting the market—as stocks continue to move up. Bullish seasonality and presidential cycles prevail, along with the overall trend on the markets, which also remains bullish.

However, we at ValueTrend are preparing an investment strategy to limit the risk of the portfolios we manage in the event of a mid-year correction. Such hedging activity—going forward—may include the following:

■ Raising cash. We tend to sell out of seasonally unfavorable sectors and “higher beta” stocks by the spring. (Beta refers to a stock’s volatility compared to the index. A stock with a beta of 1.0 moves in perfect sync with the index. A beta above 1.0 indicates a stock is more volatile than the index.)

One specific sector that we are currently long on, but expect to reduce exposure to is consumer discretionary. We own, but expect to trim our holdings in, the SPDR Consumer Discretionary Exchange-Traded Fund, or “ETF”, (NYSE─XLY).

We also expect to reduce or eliminate our exposure to U.S. small-cap stock exposure, and our U.S. banks exposure. I’ve written about the BMO Equal Weight U.S. Bank ETF (TSX─ZUB) in The MoneyLetter before. We expect to hold this until early spring, and then sell it.

■ Reducing U.S. dollar exposure. We want to reduce the potential downside of a rally on the Canadian dollar as (if-and-when) oil bottoms and recovers. By focusing on selling some, although not all, of our U.S. stocks, we will reduce our exposure to the U.S. dollar, and capture profits made as that currency outperformed the loonie over the past year.

■ Increasing commodity exposure. Ironically, the worst place to be invested over the past few years has been in the commodities trade. However, in light of a potential flattening of the U.S. dollar’s strength, we are considering the entry into certain commodity positions that will benefit from a weaker greenback. Although not a perfect negative correlation, some commodities such as oil and gold can be played against the U.S. dollar.

To play oil, which is our preferred investment strategy as and when that market puts in a bottom, we will be examining commodity-based ETFs such as iPath’s exchange traded note, iPath GSCI Crude Oil (NYSE─OIL), or Horizons NYMEX Crude Oil ETF (TSX─HUC). To trade the energy equities, you can buy an ETF such as iShares S&P/TSX Capped Energy ETF (TSX─XEG) or an individual energy stock.

■ Using hedge-type ETFs. Not all ETFs are designed to benefit from a rising market. Some are designed to rise on a declining stock market.

One of my favorites in the latter category is the Ranger Equity Bear ETF (NYSE─HDGE). This ETF works precisely as it should in a bear market due to its almost perfect negative correlation to the S&P 500. In other words, the ETF tends to rise when markets fall, and vice versa.

The managers of the ETF accomplish this by short-selling stocks that their analysis suggests are overvalued. While not a security to own in a bull market (given the fact that all ships tend to rise with the tide, which will negatively affect this ETF), Ranger Equity Bear ETF can hedge your risk in a declining market.

By owning such an ETF, you are investing in a strategy that shorts the companies most likely to fall in a bear market. I favour this type of hedging strategy over buying inverse ETFs.

The limits of using hedge-type ETFs

Having said that, I recommend holding only enough of such an ETF to offset the volatility that you perceive your other portfolio holdings may experience during a declining stock market. I do not recommend “betting” on a bear market by holding bearish ETFs as your sole investment strategy.

Investors do not need to be the victims of a bear market. By considering the above strategies, you can limit the risk of your holdings, and profit by—rather than be victimized by—bear market conditions.


The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

Comments are closed.