As the markets attempt to find sense in what’s going on with the COVID-19 virus and what it means for the economy, investors are understandably concerned and often unsure what to do. Earlier this week, many of our models made small changes and I wanted to relay some key points regarding the market volatility and why those changes were implemented.
Fear feeds upon itself and right now is spreading faster than any virus can. Often the first reaction is to freeze, which is not a bad reaction in this case because the COVID-19 data is not all in and not fully understood. The real power is in the numbers and right now there’s no way to know how it will work out. It’s not all about the virus – what we don’t completely know is how deeply the companies affected by the virtual shutdown of big segments of the world economy will be hurt. We’ll probably know a lot more about the virus itself by the end of March but after that we’ll see how it affects the economy.
The changes in some of the models were subtle. Small cap stocks and mid cap stocks typically underperform larger companies in times like this so their allocations were reduced or eliminated. We also reduced foreign stock allocations as these are generally underperforming US stocks. For most portfolios we increased cash and bond exposure, but by less than 10% in all cases. This is to keep the portfolio risk in line with what you have indicated you want.
After the freeze reaction many investors have, we often see a fight or flight reaction. Because we have had risk conversations with virtually all clients in the past few years, we’ve had remarkably few calls during all of this (and almost as many calls about investing more money since the market is down). So there’s definitely a “fight” reaction from clients so far. That’s a positive, and making sure your risk tolerance is where you want it is crucial because it helps prevent decisions you may regret. If you want to revisit your risk tolerance, please call me.
The markets have been climbing through a “wall of worry” for decades so I am not greatly concerned about their resilience and eventual rebound. Cooler heads will eventually prevail. Having said that, we implement models that attempt to provide returns that can exceed their benchmarks over longer time periods while reducing a portion of the up-and-down volatility. If done successfully, this shortens the time it takes to make back the money from those market drawdowns. These models are all structured to be within the risk tolerance you selected. Investing is not an exact science however, so “black swan” events can happen which give you results outside of what you might expect. Right now, we aren’t there with this COVID-19 event but of course that can change.
Some of our models are rules-based relative strength models driven by Dorsey Wright, a NASDAQ research firm. These “rules” about what to buy, when to buy and when to sell are based on years of testing. Although they attempt to position into asset classes and sectors of the economy that exhibit the most relative strength, they don’t trade often because they have found that there is not enough extra long term benefit in doing that. What I’ve seen since we’ve used them is that, relative to the general stock market, they do very well in “up” markets and they have been doing about the same as the general markets in “down” markets. In severe times their rules dictate if and when they move to less volatile assets classes such as cash or bonds. If they move to cash or bonds, it’s because those asset classes have more relative strength at that time. Their moves may sometimes appear counter intuitive, but I believe the relative strength concept has added value. While they are more volatile at times than our more diversified portfolios, my back-testing shows them to very competitive over market cycles.
In summary, we will continue to follow the risk-based models that guide our recommendations. If you believe your risk tolerance has changed, I’d suggest calling our office and discussing this. A more conservative model or strategy may be more appropriate for you. As for investing new money, I don’t believe this is a time to make big bets on anything. The market will sort itself out when more is known about COVID-19. For more information on that, I’d suggest checking out the Johns Hopkins CSSE website .
As always, we thank you for your past business and hope to continue earning it in the future.
Mike