With markets in free fall over the past two days, the question for investors is what to do? Here is a quick list of things that I go through in market downturns:
1. Don’t panic – assess the situation rationally.
Retail investors have a distinct tendency to buy when markets have risen and sell when they have fallen – i.e. buy high and sell low. You need to make a rational assessment of where the market is, what further downside is possible.
Right now we have economic conditions in the US starting to boom, dragging the rest of the world higher through increased demand. Additionally, the USD has fallen significantly (before yesterday), exacerbating US demand growth.
On the flip side assets are expensive everywhere. Investors are concerned that inflation is going to rise and so the long end of the bond curve is rising, which has negative implications for equities.
If you believe:
- inflation is going to shoot sharply higher and necessitate interest rates rising to 4% or so then you would be selling with the view that this is the start of something more sinister.
- inflation pressures will be temporary and relatively contained to the US market, then you will be looking at this as an opportunity to buy
2. Do you have enough cash?
You will always wish that you had more cash and fewer stocks.
However, you need to consider objectively whether your asset allocation is appropriate.
For example, our Tactical Growth portfolio has a typical weighting of 10% cash & bonds. We currently have about 35% cash & bonds. Do I wish it was higher a few days ago? Sure. But, realistically there is always a trade-off between risk and return and no-one has perfect foresight. On balance, I’m thinking about how much lower the market will need to get before I deploy cash rather than whether I need more.
3. Are your hedges working?
The point of a portfolio is to diversify your risk and to have a range of assets that will perform differently.
You need to assess (quickly) whether your hedges are working – has something changed that means that this time your hedges are not reacting in the expected manner.
For our part, our key hedges are:
- the Australian dollar which has been falling to offset the fall in international markets (tick),
- cash (tick)
- government bonds which have been falling at the long end, rising slightly at the short end (question mark)
As a quick side note, days like today are where you see that there is a big difference between government bonds and corporate bonds. Corporate bonds do not generally rise when markets sell off, they are usually not a good hedge on equity performance.
4. Quality often get sold at the start
At the start of market corrections, hedge funds and leveraged investors want to move quickly and so tend to sell their most liquid assets – and these are often quality assets. The poorer quality assets will be sold over the following days.
What this means is opportunity. We will be looking for quality stocks that have been sold down too far (in a relative sense) and look to trade out of similar exposures we have.
Market corrections are often good opportunities to “trade up” the quality curve to take advantage in particular stocks where prices have been affected.
5. When do you deploy cash?
This is the key question.
No one can consistently pick market bottoms, my preference is to not be too aggressive in chasing the immediate market bottom.
Our current base case is that this is a shorter term correction rather than the start of a major market decline. Markets got overheated and the froth needed to come out. Underlying that is a still strengthening US economy that can deliver profits growth for some time yet. Indeed the issue today is that the falling US dollar is threatening to overheat the US economy. If markets act rationally the USD will begin to rise and head off the correction.
The risk case is that this does not happen and the boom is corralled by rising yields and falling stocks instead.
One final consideration. There has been a “short volatility” trade that many hedge funds and investors have been investing in, this trade has made a lot of money in the past six months but it is undoubtedly unwinding at the moment, exacerbating the downside. If this is the case, then we may see more downside, but there could be a sharp bounce at the bottom once the unwind is exhausted. More on this later.
Damien Klassen is Head of Investments at Nucleus Wealth.
The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.