This year has been another good year for the S&P, with a year-to-date total return of 9.9% (as of 6/28/17). Investors are asking, “How have I done versus the index?” thinking predominantly of return and not risk. Very few investors are asking, “How am I protected against the next recession.” The memory of 2008, or 2000 to 2002, or 1973 to 1974, etc. is fading. A recent survey conducted by GoBankingRates found 68% of respondents said their portfolio strategy “DOES NOT ACCOUNT FOR THE POSSIBILITY OF A RECESSION.” The old saying comes to mind, “If you fail to plan, then you plan to fail.”
What could make 68% of investors behave irrationally, giving no thought to the possibility of a recession given how many recessions they’ve had to endure?” We believe there are a couple of factors, one of them being the consistent returns earned in the stock market since 2009. As the saying goes, “Time heals all wounds.” Now that investors have SEEN the recovery, they BELIEVE the stock market will just continue to go up. Unfortunately, this is an emotional response and investing for the future based upon the past has a history producing of poor results. A second factor is many investors seem to believe “This time it is different.” The fund flows into passive equity index funds (ETFs) seem to suggest these investors believe their chosen index fund is providing enough diversification that they will not get harmed; they believe this time it will be different because this time they own the index.
We want to address these two beliefs. With respect to the market’s history, it’s important to know that we are MUCH NEARER a MARKET HIGH than a market low. We of course know this; it seems we can’t go more than a week or two without hearing in the news about new market highs. However, for many investors, hearing about new highs is triggering their “Greed Response,” where they “NEED TO BEAT THE INDEX.” Perhaps it would be more prudent if it were triggering their “Fear Response,” and their reaction were that it’s been a great ride since 2009, and it would be wise to protect their gains over the last 8 years, rather than risk giving it all back. Using Warren Buffet’s words, “Be fearful when others are greedy, and be greedy when others are fearful.” Returning the mantra of “Buy low and sell high,” now would be a more appropriate time to reduce portfolio risk than 2009 was, even at the price of underperforming the index.
The next issue we want to address is the apparent belief that “This time it’s different.” We would contend passive index investing may not provide as much protection as some would like to believe. By looking under the hood of the S&P 500, we identified where the returns this year have come from. We found that the technology sector alone provided 49.5% of the S&P’s total year-to-date return. More interestingly, we found that only 5 companies in the S&P 500’s technology sector (Apple, Microsoft, Facebook, Google, and NVIDIA) accounted for 56.3% of the technology sector’s performance. In other words, while investors have owned the S&P 500 to get a diversified return stream, they really have received a very focused return stream where 1% of the S&P 500’s companies have provided 28% of its gain.
Further, “Market Cap Weighted Indexes (like the S&P)” are programmed to buy high and sell low. Why? Because “Market Cap Weighted” means that as a company gets more expensive, it becomes a bigger weight in the index. If you would have bought the S&P 500 in 1990, when “Technology” was considered no big deal, you would have bought a 6% exposure to the Technology Sector. And if you would have bought the S&P 500 in 1999 at the peak of the tech bubble, you would have bought a 29.2% exposure to the Technology Sector. From 1990 to 1999, the S&P 500 Technology sector enjoyed one of the highest growth rates the markets have ever seen, growing at over 1200% for the decade. From 2000 to 2010 however, the S&P 500 Technology Sector returned to investors a -46% rate of return. Clearly, we would have wanted to reverse our weighting in Technology such that we would have owned 29% in 1990 and 6% in 1999. This asymmetric return profile is why so many investors experienced what we now call the “Lost Decade (2000 to 2009),” where the total return on the S&P 500 was less than 0%.
Now we turn to what we’re doing to prepare portfolios for a possible recession. Historically speaking, we would have used investment grade or government debt (bonds). However, in today’s ultra-low rate environment, it is difficult to find high quality bonds that will keep up with inflation, let alone outperform inflation. So what do we do now?
We look to other investment classes that can provide a higher income stream than investment grade debt (high dividend paying stocks, MLPs, preferred stock, etc.). We also begin to contemplate carrying higher levels of cash. If a portfolio needs to produce a 5% rate of return to support its distribution rate, combining a portfolio yield of 3% with a cash position of 6% ensures the portfolio can meet its distribution demand for 3 years without the need to touch principal. We also know U.S. stocks have achieved positive returns 82.9% of the time over a rolling three-year period. What this means to investors is that if they needed to sell any stocks to meet distributions demands, there is an 82.9% chance they would do it at a gain, or in other words, they would have bought low and sold high 82.9% of the time. We believe this outcome justifies the nominal reduction in return because of an elevated position in cash.
We also introduce non-correlating asset classes that tend to perform well when recessions come. Reducing the correlation of portfolio investments increases the probability that we will be able to sell assets at a gain if the need should arise within or after the 3 year period we’ve covered with income and cash on hand.
Please call or email us with any questions or concerns.
Categories: Monthly Market Commentary