In Sickness And In Health, How Will Your Strategy Hold Up?

12537951_sAnyone who has had or currently has a significant other knows that when everything is going right, every relationship seems perfect. But the truly great relationships, the ones that last for the long haul, are able to survive even during the rough times. Those are the times that separate the truly solid relationships from the weak ones, the winners from the losers. At least that’s what I tell my wife, Jill, as we approach our 20th year anniversary in November. Yeah, we have had some tough times, but we always try to learn from the tough times so the good times are even brighter. And it has worked. Heck, I still cannot believe that she has put up with me for 20 years.
But you see, the same litmus test should be applied to financial decisions. Everyone feels confident about their investment decisions and their retirement future when the market is doing well. Just think of 2006, I’ll bet you were feeling pretty good about your financial plan. Then fast-forward to 2008, things likely looked a bit darker, stormier, didn’t they? Unfortunately, it seems that people have a short-term memory when it comes to financial decisions and events. Now, 66 months into what some call a bull market, everyone has their rose-colored glasses on again. But all good things must come to an end, and now it’s time to take a critical look at that financial relationship you are in and ask yourself, when that next rough patch hits, what will that relationship look like? Did you learn from past mistakes?
Look, secular market cycles occur over long periods of time. Why do they occur? Put simply, as the economy and financial markets go through extended periods of sustained expansion, known as secular bull markets (just as they did from 1921 to 1929, from 1949 to 1968, and from 1982 to 2000), they accumulate various excesses, including increasingly misallocated capital, lax regulations, as well as too much leverage and debt. The economy and markets eventually overheat and enter into extended secular bear market periods where the excesses from the past secular bull market are worked off and consolidated. This is what took place from 1901 to 1921, from 1929 to 1949, and from 1968 to 1982. And this is exactly what is happening today.
Although there may be both bear and bull market periods during a secular phase, the secular market phases take 17 years on average to play out. So, if the latest secular bear market did indeed end with the market bottom in March 2009 (as some suggest), it would represent the shortest secular bear market in history, by nearly one-half. Perhaps this is true, but I am not buying it. And neither should you.
This is a crucial piece of information for you to understand because the strategy you adopt during a secular bear market, which doesn’t end until the economy and markets have fully cleansed their excesses, can have a significant impact on your financial future.
There are two major schools of thought relative to financial strategies, one evaluates performance by using relative rates of return while the other strives for absolute rates of return.
An absolute rate of return strategy allows the investor to take advantage of volatility by being more conservative when prices are high and more aggressive when prices are low. It is a strategy designed to do whatever it takes to minimize market losses and to try to capture a majority of the gains when the market recovers. A fancy term for this is a tactical asset allocation strategy. The greatest advantage of this strategy is the flexibility it gives to the investor to keep losses small in bear markets, thereby preserving capital and compounding returns during the next rally. With this strategy, when market direction is unclear, absolute return managers go to cash to protect the downside.
Strategies using relative rates of return, on the other hand, are often referred to as buy and hold asset allocation strategies. With such an approach, an investor splits a portfolio between large caps, mid-caps, small caps, and bond sectors, and then rebalances those allocations based upon performance. So if large caps are up, then at the end of the year, some of the portfolio is moved out of large caps and reallocated elsewhere. Such a strategy works great in secular bull markets when stocks are consistently rising. But what happens during a secular bear market? Well, what happened to you in 2008?
Depending on which economic journal you read, the secular bear market we are currently in may not end until at least 2024. This is important to understand, because in times of a secular bear market we have significant volatility, which means that when times are good, they are really good, but when times are bad, they are really bad. Folks who have prescribed to a relative return model, a buy and hold model, may have made their money back, but we are six years into a recovery (a bull market period within the secular bear market). What will happen when times go south?
The lesson is this—rather than tying your portfolio to a benchmark, employ a strategy that strives to stay positive no matter what happens to the S&P or any other benchmark. Beat zero and focus on cumulative rates of return.
Isn’t what we want to know that if we had a buck five, 10, even 15 years ago, what that buck is worth today? Of course we do. So the goal is to beat zero.
Here’s what we know: China’s economy is slowing, the price of oil is slumping, the prices of global commodities are falling, the tech market has burst, and the US markets are overvalued. What does this mean? That “sickness” part of “in sickness and in health” could be approaching. How will your strategy stand up?
Be vigilant and stay alert because you deserve more.