Managing Stock Market Risk

There are several types of risks an investor faces and hopes to mitigate when he or she invests in the stock and bond markets.  I believe they are as follows.

Stock Risk

Buying individual stocks is an option available to investors.  This approach contains risk that is known as individual stock risk and encompasses the many things can happen and have happened to what are considered quality individual companies, which has caused their stock value to drop overnight.  Events like, but not limited to, the resignation of a CEO, a scandal associated with that company, a regulatory issue, missed earnings estimates, lowering of expectations, or downgrading of the stock by an analyst represent just a few factors contributing to this.

Purchasing a mutual fund or exchange-traded fund (ETF) in that sector is one option that may mitigate this risk.  Diversification potentially lowers individual stock risk while creating exposure to a “basket” of stocks in that particular industry.

Stock Market Risk

Stocks are known as equities; stock type funds are known as equity fundsIndividual stock risk is mitigated by the diversification of the fund, but stock market risk is retained when one invests in an equity fund (like Large Cap Growth, Mid Cap Value, or even sectors like healthcare or technology as examples).  Generally, if there are broad losses in the stock market (equities), equity indices and sectors tend to lose value as well.  This may not always hold true because it is possible for some equity indices or sectors to actually rise when most stocks are declining.  Funds that move opposite from another fund or from the market are said to be non-correlated.

In our view, the problem for the investor is that the strategy of using equity indices that are non-correlated is can potentially be inconsistent from one time period to another.

The traditional way of mitigating this risk is to use assets that tend to be non-correlated.  The most common be non-correlated assets are bonds or bond funds.  Usually, the investor will select some combination of bonds or bond funds to sit alongside his or her equity investments.  Combining equities and bonds or bond funds are referred to as asset allocation and is considered both an “art” and a “science”.  Other assets like commodities or precious metals also tend to be non-correlated and can also be used to lower equity risk in portfolio optimization.

Bond Risk

An investor is essentially lending money to an entity – whether to a government or a corporation – when he or she buys an individual bond.  The entity agrees to pay the investor a specified rate of return and agrees to return the original investment at “maturity” (the length of the term).  Another word for bonds is “debt” – the investor is the lender and the entity is the borrower.

Generally, there are three kinds of bond risk.  The first, credit risk, is the potential uncertainty of the entity to meet its obligations – to pay the investor the agreed upon interest and eventually return the invested principal to the investor.  When an entity fails to pay the agreed upon rate of interest and return the original invested principal to the investor, the bond is considered to be in default.  There have been many notable government entities and corporations that have defaulted on their bonds, thus failing to meet their agreed upon contractual obligations.  Two higher-profile examples that come to mind are General Motors and Orange County, California.

The second kind of bond risk is related to interest rates.  Bond prices are inversely correlated to interest rates;  as interest rates rise, bond prices fall, and vice versa.  The risk that an investor faces is that interest rates will rise after they buy bonds.  The investor and the borrowing entity are both locked into the agreed upon interest rate and term of the bond, which are typically not renegotiated if interest rates rise.

The third kind of bond risk is liquidity risk.  Short-term bonds (2 years, for example) are considered to have the most favorable liquidity, but also pay the lowest interest rate to the investor – and vice versa with longer term bonds.

Ways to mitigate bond credit risk (related to the issuing entity) is to buy high quality bonds (for example, AAA rated).  By diversifying types of bonds purchased and staggering purchase dates and the maturity dates, liquidity and interest rate risk may also be mitigated.  This process is called “bond laddering”.

Bond Fund Risk

Any or all of the above risks can be present when buying individual bonds.  An alternative to investing in individual bonds would be through the purchase of bond funds or exchange traded funds.  These types of funds are collections of bonds that have been purchased by fund managers.  The underlying bonds in a bond fund typically offer diversification in quality, duration and the bond issuer.  This sounds reasonable, but the question remains, where is the risk?

The fund does pay a dividend which comes from the underlying bonds which the fund owns.  However, the price of the bond fund also typically fluctuates because an investor cannot lock in a specific bond price.  Factors such as changes in interest rates can drive the value of the bond fund up or down.  Bond prices are inversely correlated to interest rates; as rates rise, the value of the bond fund tends to decline.  The biggest risk in owning bond funds is that interest rates will rise and the value of the bond fund will potentially decline.

Risk in Active Management

An alternative approach to asset allocation is active investment management.  While there are no guarantees, active management seeks to produce better returns than those of passively managed index funds.  Those who utilize active management apply methodologies that actively change assets or asset classes to reflect changes in risk and market conditions.  Through these methodologies, managers seek higher rates of return and/or lower risk.

The risk in active management is that historical patterns may not necessarily be repeated in the future.

The best way to mitigate this risk, in our judgment, is to perform a “stress test”, which tests the methodology through the periods of time for which it was not optimized.  This can get technical, but there are ways to validate active management models.  Real-time results are also a way to view performance and risk.

Conclusion

Famous investor and money manager, Seth Klarman, said, “Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose.”  Both rate of return and risk need to be evaluated together.  There is long-term value in placing high importance on mitigating risk.

Each approach to investing can use risk management to match the risk tolerance of the investor and to provide a satisfactory investing experience – and help meet his or her investing goals.

Ben Reppond is CEO and Investment Manager of Reppond Investments. Reppond Investments, Inc. is a registered investment adviser in the States of Montana and Washington. We may not transact business in any state where we are not appropriately registered, excluded or exempted from registration. Individual responses to persons that involve either the effecting of transactions in securities or the rendering of personalized investment advice for compensation will not be made without registration or exemption.

Investment Advisory Services offered through Reppond Investments, Inc.

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What would Hyman Minsky say about this stock market?

What would Hyman Minsky say about this stock market?

Hyman Minsky, a well-known 20th century US economist, was professor of macroeconomics at Washington University in St. Louis and a distinguished scholar at Levy Economics Institute at Bard College.  He is best known for developing his financial instability hypothesis.  Minsky stated that the greater the stability of the stock market, the greater the instability that follows.  My version of this is that the more the stock market moves up without a correction, the further it will fall.

Minsky’s Hypothesis

Minsky unveiled this theory in 1992.  He died in 1996 and did not live to see the tech bubble of 2000-2002 or the US housing bubble of 2007-2009, both demonstrations of his hypothesis.  During the years preceding these market collapses there were “bubbles” building inside the stock market.  They were detected by a few experts, but were largely ignored or explained away by “Wall Street” and many investors.  It was commonly believed that an investor needed to “get onboard” or be left behind as was aptly portrayed in the movie, The Big Short.

Hyman Minsky

I suspect that if Minsky were alive today, he would continue to stand on his hypothesis, “The greater the stability of the stock market, the greater the instability that follows.”  In my opinion, this stock market is the perfect example which has led to previous collapses.  Sir John Templeton said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.”  It seems that we are either in the euphoria stage – or close to it.  I frequently hear people talking with glee about how high the stock market is right now and how much money they are making in their 401(k)s or brokerage accounts.  I do not hear people having a realistic understanding of the cyclical nature of the stock market booms and busts.  However, I believe that Minsky would be extreme caution.

Where do we go from here?

I would not advocate that an investor sell all of their equity holdings and get out of the stock market. There may be more gains left in this euphoric bull market.  Truthfully, no one knows when the bull market will end nor do they know how.  However, it certainly seems like it is on the euphoric end of the cycle and, as Mr. Templeton said, historically euphoria has led to the end of bull markets.

In conclusion, now, more than ever, is a good time to start thinking about what a good defensive investment strategy would look like.  Whether you are a buy-and-hold investor or use active investment management now is an excellent time to match your allocation or strategy with your risk tolerance.  It is also a time in which wise investors know exactly what they own and why they own it.

Strategy and knowledge could greatly enhance successful portfolio management during the next bear market.

 

Ben Reppond is CEO and Investment Manager of Reppond Investments. Reppond Investments, Inc. is a registered investment adviser in the States of Washington and Montana. We may not transact business in any state where we are not appropriately registered, excluded or exempted from registration. Individual responses to persons that involve either the effecting of transactions in securities or the rendering of personalized investment advice for compensation will not be made without registration or exemption.

 

Investment Advisory Services offered through Reppond Investments, Inc.

If Hindsight is 20/20, what is Foresight?

In my article of December 20, 2017, I was urging investors to take a more cautious approach to investing in 2018.  For those in retirement or nearing retirement, traditional asset allocation did little to protect portfolios from decline in the last two weeks.  Many revere Warren Buffett.  Think about how much risk he was taking, because his Berkshire Hathaway shares declined over $11.2 billion in a single week.

In my view, tactical investing is the only way I know to potentially lower this risk. Tactical investing is a mathematical way of measuring stock market risk and seeking to minimize stock exposure when risk of owning stocks is too high.

There is no perfect answer for minimizing stock market risk in all market conditions.  However, on February 8th, sidestepping risk in conservative portfolios seemed like an alternative answer to traditional asset allocation investing.

Investors need to ask themselves one simple question:  Given my results on February 8th, how much risk have I been taking – and is that acceptable to my investing temperament?

 

Ben Reppond is CEO and Investment Manager of Reppond Investments. Reppond Investments, Inc. is a registered investment adviser in the States of Washington and Montana. We may not transact business in any state where we are not appropriately registered, excluded or exempted from registration. Individual responses to persons that involve either the effecting of transactions in securities or the rendering of personalized investment advice for compensation will not be made without registration or exemption.

Investment Advisory Services offered through Reppond Investments, Inc.

The Value of Tactical Investing in a Falling Stock Market

When the stock market begins to fall, investors ask, “How do I protect my investment?” it is not as simple as just selling everything and sitting in money market.  First, this could trigger long-term or short term capital gains.  Second, this market correction could be brief and one would miss the opportunity for future potential gains.  In other words, if you are going to try to time the market, you have to be right twice – when you get out and also when you get back in.

People I have talked to about their experience in 2008 have told me that they got out of the market at the wrong time and missed all or most of the gains that followed.  It almost takes being clairvoyant – knowing in advance when to get out and when to get back in.  I don’t think anyone knows how to do that.  And, if you are right this time, you may not be next time. The stock market is a complex place to know how to make money and lower risk at the same time.

The traditional answer is to blend bonds or bond funds with stocks or stock funds.  This has worked well for the last 35 years – during a period of falling interest rates. I do not see how the blending of stocks and bonds to lower risk is dealt with in a period of rising interest rates.

The issue is that if interest rates continue to rise, bonds and bond fund prices will fall.  What if the stock market falls at the same time?  I can find no textbook answers to that question.  I have asked financial advisors how they handle this dilemma.  I’ve never gotten a good answer.  All they know is to tell investors to ride it out.  How encouraging is that?

My answer to this dilemma is something I call tactical investing.  While there can be no guarantees, tactical investing is an emotionless mathematical way that reacts to specific signals that point to higher market risk. It also reacts to signals that point to potential upturns in the market – all with the goal of minimizing the downside and participating in the upside.

I spent 10,000 hours in research from 2009 to 2014 studying the patterns of 2008 as well as previous crashes.  From that research, I built a mathematical model based on historical patterns – designed to potentially minimize downside risk and participate in the upside of the market.

I completely acknowledge that this mathematical model is not perfect.  It does not completely eliminate all risk, nor does it capture all of the upside in an upwardly trending market. However, this is the only way I have found that does both to my satisfaction.

Tactical investing is ideal in an IRA, but in certain conditions can also be achieved by tax-deferring gains with taxable money.

Think about tactical investing as a way to potentially moderate downside market risk without compromising upside participation.

 

Ben Reppond is CEO and Investment Manager of Reppond Investments. Reppond Investments, Inc. is a registered investment adviser in the States of Washington and Montana. We may not transact business in any state where we are not appropriately registered, excluded or exempted from registration. Individual responses to persons that involve either the effecting of transactions in securities or the rendering of personalized investment advice for compensation will not be made without registration or exemption.

Investment Advisory Services offered through Reppond Investments, Inc.

Davos as Contra-Indicator

Davos as Contra-Indicator

Euphoria at Davos may be a sign that the market melt up may soon begin to cool.

By Scott Minerd, Global CIO

Two years ago, when I last attended the World Economic Forum in Davos, a growing consensus saw the global economy at the brink of recession. The spread between credit securities such as bank loans and high-yield bonds had dramatically increased relative to lower-risk assets like U.S. Treasury securities. Stocks had sold off, and many pundits predicted that we were at the brink of a new bear market. Oil was collapsing toward our earlier established target price of $25 per barrel for West Texas Intermediate. Declining asset prices were offered up as full evidence that the U.S. and probably the entire global economy was at the precipice of recession.

At the time, we argued that correlation was not causality and that oil, stocks, and high-yield bonds were approaching a bottom. In our clients’ accounts we were increasing exposures to high beta asset classes such as mezzanine collateralized loan obligations (CLOs), bank loans, and high-yield bonds. While we stayed the course with our client portfolios, the consensus at Davos led me to conform by allowing for further price erosion when I should have pounded the table that it was time to buy. Fortunately, my words did not exactly match our actions. I remember explaining on a CNBC appearance that no one can time the bottom, and despite any comments to the contrary it was time to start buying on weakness. The good news is our investments performed well as we continued to load up on energy exposures and leveraged credit risk in the form of mezzanine CLO securities.

As things kick off here in Davos, the sentiment could not be more radically different from January 2016. Global growth is accelerating and risk assets are soaring. Sentiment is so positive, it feels like the discussion will focus on “How high is up?” This is occurring in the face of U.S. tariffs on solar panels and washing machines, while CNN and the BBC run documentaries on a rising tide of nationalism, and against a backdrop of discussions on restricting immigration just when healthy Western economies are starting to experience labor shortages in certain key industries.

While I am still a Davos neophyte—it is only my fifth visit to Davos—I am starting to consider that Davos may be a valuable contra-indicator. A few years back the big story here was about the emergence of Africa onto the global scene as an important component of future global growth. While I think that view is ultimately correct, the immediate experience proved very disappointing for investors. Rather than a buying opportunity, investors would have done better to go short for the near term.

While I am hesitant to jump to a conclusion, I am troubled by the euphoria undergirding the gathering here. I will be listening closely and speaking occasionally, most likely asking more questions than providing opinion. I have seen bull market tsunamis before. They can be both rewarding and destructive. The key is to know when to get out.

 

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