WindRock - Displaying items by tag: Equities

Profiting When Stock Markets Fall

Published in Podcasts
Thursday, 21 January 2016

With increasing signs of a global recession, stock markets throughout the world have experienced one of the worst annual starts in history.

Many investors fear 2016 will bring another stock market downturn similar to 2000 and 2008.  While investors can protect themselves by selling equities or even shorting the stock market, both of these approaches involve potential problems.  An options strategy offers a third alternative with the potential for sizeable profits.

WindRock interviews Ed Walczak, Senior Portfolio Manager of the Catalyst Hedged Futures Fund, about the use of an S&P options strategy.

January 2016.

Defense Wins Games

Published in Blog
Friday, 04 September 2015

September, 2015

Football fans always get excited about offensive prowess, but they also know that when it counts, it is defense that wins games.  After a seven-year run in the U.S. stock markets leading to near-record valuations, veteran players know it is time for some solid defense by reducing risk in equity portfolios.   The question for investors is: how to play defense in this increasingly uncertain world?

There are three primary ways to reduce equity risk.  First, by significantly reducing equity exposure or exiting the equity markets completely.  Traditionally, proceeds from equity sales are reinvested in bonds to await cheaper equity prices.  This strategy has often worked in prior market downturns – and it may initially work with the next one – but we foresee a day when bonds sell off along with the stock market.  It also requires some market-timing expertise.

The second strategy is the traditional diversification model touted by mainstream financial advisers.  This model includes a broad mix of higher risk-assets in order to reduce overall portfolio risk.  The theory states that, by mixing U.S., international, small and large-capitalization stocks, overall risk is reduced since these stock categories typically do not move in lockstep.  This theory has led many investors to actually increase their overall equity portfolio risk (as we have recently experienced) since equities in different corners of the globe can all quickly tumble together during a contagion.  So although traditional diversification may prove beneficial during normal times, it fails miserably during periods of systemic crises such as 2008.  In our view, record debt levels throughout the world, combined with unprecedented monetary expansion, increase the likelihood of systemic risk.

Hedging, the third and most compelling method to reduce equity risk, uses assets which should increase in value as stock markets decline.  Traditionally bonds have performed this task, but as discussed above, those days may be ending.  An asset which may now fulfill that role is volatility itself.  Today, volatility is a tradable investment vehicle.  Commonly referred to as the “VIX”, volatility reflects levels of risk in the stock market and rises as investors become more fearful.  In two consecutive trading days in late August (2015), volatility rose by over 45% each day.  The increase in volatility from the August low-to-high was over 230%!  However, other than periods of turmoil, the VIX is often flat or slowly declining.  Therefore, an active-management approach is essential.

There are several investment funds which employ strategies that allow participation in rising equity markets, yet utilize volatility to eliminate or at least mitigate the risk of bear markets.  Some volatility investment vehicles can even have exceptional returns during deep equity drawdowns.  Even small positions in volatility can provide substantial benefits during market downturns.  Today, volatility should be considered a key asset class and legitimate strategy for playing defense against the risk of a systemic crisis.

Could Equities Fall Back to 2009 Levels?

Published in Blog
Wednesday, 10 September 2014

October, 2014

Yes, according to historical data on previous bear markets.  The average bear market has wiped out over five years of gains with an average decline of 38%.  However, the three deepest downturns (as measured by the duration of the previous bull market wiped out) each negated approximately 12 years of returns on average.  During the last downturn ending in 2009, a 60-year old investor would have seen their wealth evaporate back to age 48!  We are not calling for an imminent crash, although we think valuations look dangerously lofty and built on the false pillars of low interest rates, accelerated stock buybacks, and government money printing.  These forces can keep pushing the equity markets higher, but they are all artificial and the pendulum will swing back once they falter.

Most investors are blinded into focusing on how they are keeping up with the S&P 500 on a quarterly basis and lured into buying more stocks as the market rises (so called “rear-view investing”).  The real experts know that building and maintaining wealth is largely an exercise of compounded math.  Making money on the upside, yes, but avoiding the big haircuts that bear markets bring.  Keep in mind that an investor who loses the average 38% during a bear market needs a return greater than 60% just to get back to even.  If an investor was able to get more defensive near the market top and held losses to half of the decline (or 19%), they would need a much more reasonable 23% to get back to even.

The experts also realize that wealth is created in bursts.  They’ve gotten rich by doing the opposite of the crowds at inflection points, but patience is a virtue.  Just when emotions tug average investors into buying more equities, the experts scale back, remain patient, and avoid the full damage of these bear markets. By doing so, they are then positioned to “play offense” near market bottoms and buy into cheap valuations as fear and uncertainty consume the masses.  For investors whose emotions are tugging them into the rising equity markets, buyer beware.


Three Lessons When Investing in a Bubble

Published in Blog
Tuesday, 17 December 2013
January 9, 2013

Investors must face the reality that policy makers have fueled yet another wave of financial bubbles with the twin policies of effectively 0% short-term interest rates and the printing of trillions of dollars since the crisis in 2008.  As evidence, look no further than U.S. equities, where the S&P 500 at its most expensive 10% in its history despite a poor economy.[1]  Whether investors want to admit it or not, it is a bubble market again.  Keep these three lessons in mind when navigating the waters ahead:

Three Lessons of Investing in Bubbles:

  1. Money printing can trump fundamentals … for a while.
  2. Most investors (and their advisors) are blind to bubbles on their mistaken belief in efficient markets.
  3. Bubbles can persist for longer than most think possible and then pop much harder than imagined.

Let us examine these findings.  How can stock markets rise despite poor fundamentals in an economy?  Easy, on the back of printed money and inflation.  On the surface, Venezuela’s Caracas stock market is the envy of the world, up 480% in 2013.  However, with inflation at nearly 50% and shortages of basic necessities such as toilet paper, the rising stock market is hardly indicative of a fundamentally strong economy - making it prone to a future crash.  In similar vein, U.S. equities have risen on the back of printed money and are expensive today.  Jeremy Grantham and his talented investment team at GMO have become legends in their ability to spot financial bubbles and forecast market returns.  Currently, they project US equities will deliver negative annualized returns after inflation through the year 2020, with small company stocks faring the worst.[3]   However, equities may keep rising first as the impact of printed money trumps fundamentals in the minds of investors.  After all, printed money needs to find a home. Abandoning equities entirely leaves an unappetizing list of choices such as 0% cash and inflation-prone government bonds.

The old adage that “markets can remain irrational longer than investors can stay solvent” holds today as the aggressive actions of policy makers have kept the party going.  For equity investors at the party, we recommend a strict two-drink limit.  In other words, keep a defensive mindset.  For money dedicated to equities, focus on undervalued areas like select emerging markets, high quality companies with global franchises, and tactical managers that can adjust when markets turn down.   Also, money printing is likely to fuel future inflation, but inflation-hedges are cheap and unloved today.  There is a golden opportunity to begin accumulating hard asset investments.  However, the opportunity is only available for investors who brave enough to deviate from the herd.

Equity investors need to be ready to pull back the reins as the clock strikes midnight and Cinderella dashes out the door with the printing press in hand. Investors relying on a traditional asset allocation strategy will outstay their welcome and experience the trifecta of wealth destruction following their experiences in 2000 and 2008.  Only a well-designed tactical allocation strategy, which acknowledges these dangers today, can invest with a quick exit in mind. 

What pops the equity bubble?  Any event that takes the money printing presses away and stops the party in its tracks.  Perhaps rising inflation and interest rates?

[1]       Based on the Shiller PE Ratio of 25.4X for the S&P 500 as of December 31, 2013.  This places the S&P 500 in the most expensive 9% in its history dating back to 1881, Source: PIMCO.

[2]       Based on data from the Wall Street Journal Market Data Center, December 31, 2013, Global Equity Returns Based on the DJ Global Index,

[3]       Based on GMO 7-Year Asset Class Real Return Forecasts dated November 30, 2013.  Source: GMO.

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