Sailing into the Coming Market Storm

There’s something romantic about sailing out to sea.

But such a pleasurable activity can quickly turn into a nightmare when weather conditions change.

The ocean is a harsh mistress. Getting caught in her wrath has always been a serious danger facing sailors.

Sudden high winds can lead to capsizing. Worse is when the sea is rough enough for waves to topple your boat altogether.

That’s why seasoned sailors are always watching the clouds.

Advancing black nimbus clouds, shaped like avails, are often a sign of a coming storm.

While some salty sea dogs say sailing through big waves and high winds is the true test of seamanship, it’s usually best to avoid storms at all costs.

But if you do find yourself in a storm on the high seas, sailors will usually try reefing. This is when you roll up your sail to reduce the effects of high winds.

If reefing isn’t possible, the next best option is to head out to open waters, away from land.

Right now, stock investors are looking at some black nimbus clouds forming on the horizon. Some have already started reefing (selling out) to reduce the impact of wind (volatility).

But let me explain why you should sail straight into the storm, and use your biggest advantage.

We’re in for a 25% drop, says Goldman

US bond yields (coupon rate divided by price) have come back down in the last few days. Wednesday last week, you could have made a ‘risk free’ 2.9%.

But since, yields have dropped below 2.85%.

Many suspect yields won’t stay this low for very long. The US Federal Reserve is intent on reducing the amount of US bonds they hold and increasing US interest rates.

To do that, they’ll need to sell bonds to the market, and increase the interest rate at which they lend to commercial banks.

The former will decrease bond prices, causing yields to rise. And if yield climb high enough, it could be disastrous for stocks.

As I’ve discussed in recent Money Morning articles, the yield of a bond is essentially a ‘risk free’ return. That’s because the government will almost certainly pay back their debt — for now, at least.

As this ‘risk free’ returns increases, stocks (because of their risk) start looking less attractive.

Yesterday, US investment bank, Goldman Sachs predicted US stocks could drop by 25% as a result of rising bond yields.

As you can imagine, such a drop would also reverberate in the Aussie market.

Bloomberg wrote:

Goldman’s base-case scenario calls for a 10-year yield of 3.25 percent by the end of 2018, though a “stress test” out to 4.5 percent indicates such a move would cause stocks to tumble, economist Daan Struyven wrote in a note Saturday. He also said the economy would probably suffer a sharp slowdown but not a recession.

Why shouldn’t this make you sail for open water? 

Don’t play the mug’s game

Trying to ‘time’ the market? Don’t be silly.

Like avoiding a storm at sea, it seems logical to do the same as a coming storm hits stock prices.

Why not take all your money out and try to avoid losses?

After all, if you reduce some of the most serious losses, you can dramatically improve your returns. Take a look at the graph below.

It shows the returns of the S&P 500 (500 largest US stocks). It also shows potential returns had you added or subtracted the 10 best and worst days.

the S&P 500 (500 largest US stocks) 27-02-18

Source: Ritholtz

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The yellow line is results with the 10 worst days removed, and the red line is with the 10 best days removed. The gap between the two makes a world of difference.

This is all well and good.

But to successfully ‘time’ the market you’ve got to have a well-functioning crystal ball. And I’m yet to believe anyone has one.

More times than not, market timers spend much more in trading costs and are generally worse off than if they had just stayed put.

In a 2017 study, it was shown that trying to improve returns through ‘market timing’ actually eroded returns over time.

As noted, all TDFs (Target date funds) have a glide path that determines how their stock-bond allocation changes over time.

However, funds often deviate from their path to try to improve returns by responding to changing market conditions.

The results show that, compared to strictly following the glide path, the average return due to market timing across all funds is -11.5 basis points per year.

Average Effects of Market Timing Decisions on Return in TDS, in Basis Points 27-02-18

Source: Elton et al. 2015

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This is not to say you can’t sell a portion of your portfolio to buy bargains as they come along. But trying to ‘time’ your investments by sitting on the sideline until the storm passes actually leads to far worse returns had if you had been fully invested, holding cheap stocks for the long-term.

It goes without saying that you’ll need a lot of discipline to sail into the coming storm and buy stocks as they rip down.

But if you can build up this pain tolerance, it will be your biggest advantage as an investor.

Kind regards,

Harje Ronngard,
Editor, Money Morning

PS: I don’t believe in ‘timing the market’. But cycles do exist, in business, credit and the economy.

Expert on these cycles is Phil Anderson. He’s developed what he calls the ‘Grand Cycle’. And this cycle actually contradicts those predictions of Goldman Sachs. Phil believes we’re still in an expansionary phase. And it might remain here for far longer than you think.

Find out more here.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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