More Volatility Ahead?
This past week I received an email from a subscriber who says his advisor is telling him to get back into the markets with two feet. He wants to know is now the time to take risk or should you be more conservative?
Here is my take:
Now everyone’s situation is different and some have higher risk appetites than others, but overall I’m still very concerned about the markets and economy. Each week we keep seeing very troubling signs. Here is just a sampling of the issues we are facing:
- U.S. 3rd Quarter Gross Domestic Product (GDP) rose at just 1.5%, far below the 3.9% growth rate during the second quarter. China has revised its GDP downward as well. Many parts of the world are now in either a recessions or full fledged depression.
- U.S. exports have fallen over 11% this year, which lines up with prior recessions. This similar trend is also playing out in China, Europe, and Japan.
- Countries like Russia, Canada and Brazil, who rely heavily on natural resource exports are feeling the severe ramifications of plummeting commodity prices.
- Manufacturing activity, a good indicator of overall financial health for a country has been steadily declining in the U.S. and China – the #1 and #2 economies in the world. We are seeing similar trends in Europe, Japan, and the UK.
- Countries around the world are keeping their countries propped up solely through central bank stimulus – keeping interest rates artificially low and printing more money to stimulate economic growth.
- The International Monetary Fund (IMF) has warned that the world economy could crash if central banks do not continue their low interest rate policies.
- Tensions with Russia and Syria could spill into a much more global war. This situation is disrupting the Middle East and world stability.
- The refugee crisis in Europe is spreading like a wildfire and could make an already fragile economic crisis much worse. Germany, which is supposed to be the strength of Europe is facing financial difficulties from its largest bank and employed. Deutsche Bank will lay off tens of thousands of workers after reporting an $8.3 billion loss. The Volkswagen emissions scandal is growing wider and wider.
- 53% of stocks in the S&P 1500 Index, which covers large, mid and small companies, have reported sales below estimates, profitability in this group is down about 2% year-over-year, and for every company expecting better results in the 4th quarter, there are two companies expecting worse results.
Where are the markets heading next?
Most think that because things “normalized” in October that the worst is behind us. I see four major problems with this type of thesis:
- Declining stock market volume. Normally, during a bull market rally you will see a spike in the market volume (number of shares traded). In October we saw declining trading volume (fewer buyers).
- The flight to safety masked what was going on below the surface. The number of advancing stocks versus declining stocks also declined. This is another bearish signal – both the Dow 30 and NYSE saw the number of declining stocks outpacing the number advancing.
- The total number of advancing stocks as a group also declined. The stocks that advanced were mostly the largest companies (Apple, Facebook, Microsoft, Google, Amazon, etc.), which carry more weight and though the indexes are rising they are doing it with fewer and fewer companies. This is also a very bearish sign for the markets ahead.
- Earnings expectations are the worst on record since the Great Recession and estimates keep going down. With the dollar starting to soar, which will negatively impact companies who do business in foreign countries (most S&P 500 companies) this will further erode corporate earnings going forward.
Classic Crash Formula
The current market still looks like it could be following the classic crash formula:
- Stock market drops (we saw this in August)
- Followed by a quick recovery (we saw this in October)
- Then comes the real collapse
The last three major market crashes were preceded by initial drops of 10% to 15% followed by sharp rebounds like the one we saw in October. Based on history, there are still high odds that we could see another big crash very soon.
Is volatility here to stay?
Prior to 2015, investors were a bit spoiled. There were six years of equity markets that seemed to only go one direction – up. Though we had some dips along the way, the markets have basically charged straight up since the Great Recession of 2008-9.
However, the second half of 2015 has seen a disturbing amount of fluctuations (volatility) that we haven’t seen since the last financial crash. There’s no way to know exactly where all of this is heading, any more than there are strategies to enable you to keep making money in less certain times.
But there are ways to prepare your investments for a more volatile market, and for a more volatile economy. Those preparations may not keep you from losing any money at all, but they may help you to be in a position to take advantage of whatever opportunities do exist.
Take a quick look at the volatility patterns over the past year or so:
As you can see, volatility spiked in August and came back down quite a bit in September and October. Is this the calm before the storm? Will we see another spike ahead? Is volatility here to stay? These are the important questions to be asking, but even more important is to have a series of strategies to deal with volatility in the event in comes roaring back. Let’s take a look at some solid strategies to help your portfolio deal with the ups and downs that will be coming our way.
Let’s take a quick look at five steps you can take right now to prepare for more volatility ahead:
- Move as Much Into Cash As It Takes to Make You Comfortable
We’re not talking about panic selling here – in fact, quite the opposite. You want to sell off just enough of your equity positions that you won’t panic. So much of investing is psychological. If you feel you have too much exposure to stocks, you will almost certainly engage in a wholesale selloff in a declining market. That will include the good stocks as well as the bad.
Even in an unstable market, you never want to be completely out of equities. For one thing, the market can always engineer a sudden reversal. Should that happen, you would be completely out of the market at the very time when the returns would be the richest.
In addition, even during bear markets, certain stocks and even certain sectors continue to rise. You want to do your best to identify these, and maintain adequate positions.
- Emphasize High Dividend Paying Stocks
It’s not so much that high dividend paying stocks will ride out a market downturn unscathed, but more that they will continue generating cash flow that isn’t dependent upon the market value of the stock. If you’ve locked in say, a 4% dividend, you will continue to receive that income despite the market gyrations.
This is important in a volatile market. Capital gains will be extremely hard to come by in such a market, so cash flow will become more important. In fact, at some point it will become more important to a very large number of investors. It is likely that high dividend paying stocks will be among the first companies to recover when the market begins to turn up again.
Equally important however is that buying high dividend paying stocks isn’t just about buying stocks that have the highest dividend yield. You’ll want a combination of high dividend yield and fundamentally strong companies. That means companies that are leaders in their fields, have a long history of steady growth, have a long history of paying and increasing dividends, and are less debt reliant than their peers in the industry.
- Unload Stocks that Did Poorly in the August Mini Crash
There was some thought that the August mini crash would ultimately turn into a serious and protracted market downturn. That hasn’t happened, at least not yet, but there’s plenty that can be learned from the event.
The market dropped about 10% from its May peak. That barely qualifies as a correction, and yet some stocks got hammered. If you expect volatility to continue, and a stock that you’re holding got beat up in August, it should merit special consideration as a solid candidate for sale.
The market indicated a lack of confidence in those stocks, that’s likely to manifest itself to even greater degree when another down leg develops. Even if a given stock had been doing very well up to that point, there is now evidence that the market views it with suspicion. If a given stock lost 20% or more during the correction, it may be time to let it go.
- Keep Funding Your Portfolio – But Keep the New Money in Cash
Whatever you do, never let a volatile market take you off of your long-term investment strategy. If you have been saving money and funding your investment portfolio during the long bull market, you should continue doing so even if the market goes into a full scale bear cycle.
However, volatile markets are not usually the best time to invest in stocks. Cutting through surface pleasantries, volatile – as it relates to investments – generally refers to a strong bias to the downside. Even though stocks are off their highs, they probably won’t represent bargain prices in a market that’s bouncing around, and highly likely to take substantial dips along the way.
Keep funding your portfolio, but use the fresh contributions to build up your cash on the sidelines. The volatility will end when the market finally settles down after a period of protracted, but totally necessary, adjustment. That will be the time to buy, and that’s what you need to be preparing your cash reserves to do.
- Seriously Consider Alternative Investments
Unfortunately, the recent volatility in the investment markets is being caused by very real macroeconomic issues. Among these issues are unsustainable levels of debt, particularly in emerging markets, underfunded pensions and other public obligations, weak global demand, and limited central bank options to fix the problems.
Given the magnitude of these issues, having a small percentage of your portfolio invested in precious metals is hardly a radical idea. Recently, 3-month US Treasury bills returned 0%; that’s never happened in history, and could represent the start of an era of volatility that’s never been seen before. Why precious metals? Stocks hate volatility – precious metals thrive on it!
In addition, you should also consider investments in strategic commodities, particularly energy. Energy is one of those sectors that has already experienced a cleansing blowout. There’s a reasonable chance that the recovery of the industry could occur even at a time when the rest of the economy is in turmoil. No matter what the state of the economy is, the world still needs energy to run on, and there’s an excellent chance that an unstable global economy will result in the kinds of energy disruptions that cause prices to explode.
BONUS: Aggressive investors could consider a play on the volatility index (VIX)
There are two ETFs that I often use to make profits when volatility increases:
- VIXY: VIX Short-Term Futures ETF – This is a 1x volatility index so it tries to capture a gain that equals the increase in volatility. For example if volatility increases 1%, this should increase 1%.
- UVXY: Ultra VIX Short-Term Futures ETF – This is a 2x volatility index so it tries to capture a gain that equals twice the increase in volatility. For example if volatility increases 1%, this should increase 2%.
At the end of the day, there’s no way to know exactly how things will play out in a volatile market. But that’s exactly why you have to start spreading some of your capital around into non-traditional investments. With such strong uncertainty in the current global economy, it is only a matter of time before volatility starts heading higher once again. Now is the time to get prepared!