Market Crash - Thoughts about Risk Management - Note 4

Howard Marks of Oaktree Capital Management, L.P. has released his newest newsletter.  It reflects his latest thinking on the investment climate and is well worth reading as he provides balanced assessment of positive and negative perspectives - also the short and long-term implications of change in U.S. tax policy.  "Proceed with caution" is his advice.

Howard Marks' January News Letter 

What to Do?

I have had (and still do have) a propensity for engaging in potentially risky activities: climbing, caving, long-distance cycle riding, wilderness canoeing, skiing etc.  Like many of my companions, I engage in risk management.  Here are a few of those practices which are relevant to the world of investing.

With the exception of the first two, they are presented in no particular order:

It's All About People

Only engage with people you can trust.  The key strategy is to avoid people who are either inexperienced, take undue risks, ignore the well-being of others in the group, or who are accident prone.  An unfortunate confluence of these factors led to a death of a friend on one trip many years ago.

re investing:

Invest only in companies with ethical management working in the interests of their shareholders ... and managers with successful track records.  Considering the risks these days, I look especially for long tenured management which has steered companies successfully through at least one full market cycle.

Strategic Thinking - Risk Minimization 

A great many accidents happen because people find themselves in the wrong place, with the wrong "stuff" (equipment, skills, mental attitude etc.) when bad things happen.  Prior to a prospective adventure, one must match one's capacity (group included) with the nature of potential situations that could arise.  It's all about the minimization of risk.  There are a few possible outcomes:

• abandon the project and do nothing
• modify the project (timing, duration, intensity, etc.)
• select a "safer" project

The key is to know one's self, be aware of potential risks, and avoid situations where they exceed one's "limits of safety".  

re investing: 

Herr Buffet states the the first, second and third rules of investing are "not to lose money".

It is inevitable that a recession will take place.  When/where/how - it's uncertain.  The last five years have been exceptional.  It's well worth considering the possibility of heading to a safe haven to enjoy gains, especially with the knowledge that the sun will shine after the storm's passage.

In a previous post, I presented a graph illustrating the impact of portfolio losses.  Here it is again:

http://observationsandnotes.blogspot.ca/2011/02/importance-of-avoiding-large-losses.html

It's all about risk reward.  In this respect, it literally pays to take the long view: to consider that it might be prudent to protect one's gains and invest one's stash in vehicles that are potentially more resilient during market declines.

Preparation and Training

Risk assessments are used to identify preparations that must be done prior to an adventure: skills and equipment required, nature of the training for members of the crew, timing, and final review.  Deficiencies of any element are rarely acceptable depending on the severity of potential consequences.

re investing:

There are several potential tactical measures to reduce investment risk.  Some of them include options and interest-generating vehicles.  Familiarization and practice with these instruments may be considered by people interested in protecting their stash.  A useful book, Options Trading for the Conservative Investor by Michael C. Thomsett (Pearson Education Ltd. 2010) is worth reading. This is only one of many excellent books on the topic.  If you are new to options trading, it makes sense to practice on virtual trading platforms in order to get a better sense of the process without having to risk real money.

Situational Awareness - Vigilance 

There are times when one can relax and others where it is important to pay close attention.  This "spidey sense is a combination of training, experience and attitude.  I never travel with people lacking this capacity.

re investing: 

While some may equate nervousness with the strategy of trying to time the market, I take a view which derives from an investing time horizon that generally is in the frame of five to ten years.  My sense of the current situation is that risk is increasing.  I have decided to adjust and apportion my portfolio on the basis of perceived risk: to place parts in "slower moving" lower areas of risk and a smaller portion in more "responsive" higher "risk" investment vehicles.  That way, I can have exposure to future gains with the hope that the bulk of the portfolio will be somewhat more resilient.  I will focus more on the more dynamic elements as opposed to spreading my efforts more widely.  It's all a matter of focus.

Contingency Planning 

Good and bad things happen - both anticipated and not.  Agility and preparedness are required to address these eventualities.  Many adventurers game out "what if" scenarios.  The very act of doing so, I would argue, prepares people to cope more readily with totally unanticipated situations as it promotes a more flexible mindset.

re investing

This is one time where it pays to read widely and to hop out of one's "reading rut" - to get exposure to ideas that one might discount out of hand.  This has two effects: challenges current thinking; offers new possibilities to be considered.  My reading has expanded to include: selected local, regional and national newspapers and government agencies; ditto for trade/professional magazines and journals.  With a few exceptions, however, I ignore the financial press.  I do read quarterly and annual newsletters from a few money managers.  The reading provides better situational awareness and, sometimes, reveals potential strategies to address emerging trends (either fast or slow moving). 

Big Salmon River - Yukon Territory

Market Crash - Storm Watch Note 3

I am reading The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction by Richard Bookstaber.  The product of a brilliant mind coupled with diverse experience, it merits a deep read.

In brief, the Bookstaber posits that traditional economic models lack the capacity to deal with economic crises - the ultimate in model stress tests as it were [my view].  His analysis of the deficiencies of economic modelling in Section II, is penetrating and is, in itself, an intellectual journey of note.  The book is worth reading for that alone.

Bookstaber's use of agent-based models opened new doors of understanding into the financial crises of 1987, 2008 and 2010.  In essence, the disruptions are explained by"stories" describing the actions of various agents and how differences in their outlook and subsequent actions disrupted the "system" when one or more of the agents was put under stress.

If anything, I learned that it is impossible to predict the timing, extent and nature of the next disruption.  As a friend of mine who has been in the stockbroking business (successfully) for 46 years recently said to me, "I've learned that you can only do the best you can and struggle through."

I am in the early stages of absorbing Bookstaber's work.  With luck, I hope to identify a few indicators which might be used to monitor the stability of the "system" but I fear that it will be a fruitless exercise.  Better to read voraciously and extensively in order to get an animalistic sense of the environment and then adapt as some conditions emerge.

For example, here is an insightful article by Ambrose Evans-Pritchard of The Telegraph:

World finance now more dangerous than in 2008, warns central bank guru

The world financial system is as dangerously stretched today as it was at the peak of the last bubble but this time the authorities are caught in a ‘policy trap’ with few defences left, a veteran central banker has warned.

Nine years of emergency money has had a string of perverse effects and lured emerging markets into debt dependency, without addressing the structural causes of the global disorder.

“All the market indicators right now look very similar to what we saw before the Lehman crisis, but the lesson has somehow been forgotten,” said William White, the Swiss-based head of the OECD’s review board and ex-chief economist for the Bank for International Settlements.

The refrain, "we've seen this before", is common to the observations of many people quoted by Pritchard-Evans.  However, my sense is that the liquidity trap, the condition of most financial crises, will be sprung somewhat differently than in previous crises:

While banks now have high capital buffers, the risk has migrated elsewhere: to investment funds concentrated in crowded trades. The share of equities traded in “dark pools” outside the exchanges has mushroomed to 33pc. “A lack of market liquidity may lead to fire-sale risk, a downward price spiral,” it said.


One worry is what will happen to ‘risk parity’ funds when the inflation cycle turns. RBI Capital warned in its investor letter that these funds could lead to a “liquidity crash”. Deutsche Bank has advised clients to take out June 2018 ‘put’ options on the S&P 500 - a hedge against a market slide - arguing that the rally looks stretched and that risk parity funds will amplify any correction.

Some readers may dismiss Pritchard-Evans as a pessimist as he often expresses rather dark views of things such as the viability of the EU and the state of world affairs.  However, it's always best to read widely and to explore new areas of investigation as a result.

For example, I followed up on some of the organizations represented by a few of the people quoted by Pritchard-Evans.  It lead to yet more insights and the further shaping of a personal "view" of the state of the global financial system - also some potential strategies to address increased levels of risk.

I hope not to be caught on the strand when the next tsunami rolls in.  Better to retreat now and enjoy the breezes from a safer location.

There are innumerable threats to the stability of the system.  Taking a lead from the aforementioned article, I started to explore findings of the Office of Financial Research.  One report in particular, Office of Financial Research Reports on Risks to Financial Stability (December 2017) lists some of the threats:

1.  Vulnerabilities to cybersecurity incidents – A large-scale cyberattack or other cybersecurity incident could disrupt the operations of one or more financial companies and markets and spread through financial networks and operational connections to the entire system, threatening financial stability and the broader economy.

2.  Obstacles to resolving failing systemically important financial institutions – There are two paths for the resolution of a failing systemically important financial institution that is not an insured depository institution. Both paths have shortcomings for handling the failure of the largest and most complex bank holding companies, known as global systemically important banks.

3.  Structural changes in markets and industry – Three aspects pose threats: (1) lack of substitutability, or the inability to replace essential services if a provider fails or drops that line of business, (2) fragmentation of trading activities through multiple channels and products, and (3) the chance that the transition to a new reference rate to replace the London Interbank Offered Rate, or LIBOR, could be difficult.

I have subscribed to receive updates on the activities of the Office of Financial Research.  If anything, I hope to gain a better appreciation of thinking processes and outlooks of various participants in the system.  And occasionally, a few tidbits about potential strategies to cope with emergent opportunities and risk.

Market Crash Storm Watch Note 2 - ratio of household net worth to disposable income

I have expanded my reading to include reports issued by various Federal Reserve Banks in the U.S.

I was impressed by the January 8, 2018 Economic Letter from the Federal Reserve Bank of San Francisco.  In my view it is yet another indicator that a market correction is in the offing.

Valuation Ratios for Households and Businesses by Thomas Mertens, Patrick Shultz, and Michael Tubbs

For me, the highlight of the report is contained in the following paragraph and the accompanying graphic.

Ratio of household net worth to disposable income

The net worth-to-income (NW/Y) ratio—defined as household assets net of liabilities divided by personal disposable income—provides a valuation metric for a broad set of assets including debt, equity, and real estate weighted by the proportion in which they are being held by households. Similar to the P/E ratio, this ratio generally tends to revert toward its historical average and does not remain at extreme values, either high or low, for prolonged periods. As shown in Figure 3, the NW/Y ratio increased notably during both the dot-com boom and the housing boom and sharply contracted during the subsequent downturns.

Government boffins are always cautious about presenting their
findings.  My antennae started to vibrate by the time I reached the conclusion of the Newsletter.

Current valuation ratios for households and businesses are high relative to historical benchmarks. Extending the analysis by Campbell and Shiller (1996), we find that the current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next 10 years. Since the Great Recession, multiple asset classes—real estate, pensions, life insurance reserves, and equities—have been the main contributor pushing the household net worth-to-income ratio to a record high. Historically, these ratios have not remained elevated for prolonged periods, and peaks have been followed by reversions toward their long-run averages. At the same time, the present circumstances, including low current and expected interest rates, may warrant caution against bearish forecasts.

In my view, the net worth-to-income (NW/Y) ratio, when combined with the observations made in previous posts, is yet another indication of difficult times in the markets.

The storm clouds are on the horizon.  Meanwhile, the party proceeds and people are reluctant to leave, fearing that they will miss out on the good times yet to come.  There will be a reckoning.

Market Crash Storm Watch Note 1 - Reducing Exposure and the Risk of Being Wrong re Timing

In my view, the market cycle is getting old.  The potential for a correction within the next year or two is significant - to the point where some prudent measures should be taken soon in order to prepare for the downturn.

With this in mind, I have started by reducing my exposure to equities in a significant way.

I take the "long view".  I have managed my affairs such that I have no debt and can live below my means if required.  As a result, I can forgo the "opportunity" to make further gains if the market increases over the next year or two.  In other words, I can afford to wait.  

In essence, my strategy is to minimize losses and yet, have some exposure to the opportunity for further gains (with the thought that they might offset, to some extent, losses when they do occur). 

A Few Givens

It is inevitable that a correction will take place.  (See previous posts.)

It is impossible to know when a market correction will occur.

It is impossible to know the extent and type of a market correction.

In light of this, what to do?  

I have experienced several corrections.  There were a few consequences:

• significant loss of money 
• reduction in the level of confidence in my ability and my faith in equities markets
• fear of investing at the end of the recession - the time when opportunities were ripe

The last two consequences are psychological.  Experience and reflection have taught me how to deal with them:

• to accept that losses are part of investing
• to realize that market cycles are normal
• to persevere through tough times

This time around, I will focus on the external - trying to minimize losses on equities due to downturns in the markets.  

The Impact of Losses

The implications of the following chart are clear:

• the need to cut losses early
• the difficulty in making gains to offset losses increases significantly with the extent of losses (which explains why so many people have yet to recover from major crashes in equities markets and the collapse of the housing bubble)

http://observationsandnotes.blogspot.ca/2011/02/importance-of-avoiding-large-losses.html

Reducing Exposure to Equities Markets

I have reduced the number of positions in my portfolios.  Characteristics of crew members who have been discharged include:

• high debt levels
• abnormally high P/E ratios
• sectors which are more prone to outsized losses during crashes
• complicated business models which are more prone to external shocks

In most instances, the reduction has been accomplished by eliminating entire holdings.  In a few, I have retained a reduced position. 

Crew members who are still on board have some of the following characteristics:

• robust financials
• leadership which has managed the company through at least one market cycle
• a market for products and services which is resilient during recessions 

The strategy is simple: easy to understand; easy to execute.  Above all, it provides resources to re-invest when market conditions improve.  Better to work from a base of strength than trying to recover painful losses.  It's better financially and far better mentally when one approaches life from the perspective of a hunter than that of a wounded warrior.  

Other Comments

• There is a variety of strategies which can be used to cope with volatility for one's portfolios.  I will use some of them.  Examples 
• Futures trading and the use of negative ETFs is also possible, but I find that timing is a real issue.  I generally have not done well with these instruments as they do not fit my style of investing.  
• There are real risks in trying to time the market.  However, it all depends on one's personal circumstances and outlook.  For example, if I have an alternative, I will not try to make a sailing passage when stormy weather is in the offing.  I've learned through my life on the water and in investing that it always makes better sense to select a protected mooring and be patient.  The experience of rescuing five people from a boat that foundered in a violent storm not more than 400 metres from our anchorage confirmed this belief.  Seeing the potential threat, we dropped the hook in a very protected spot and battened down the hatches.  Half a day later, the storm broke.  The winds of the microburst exceeded 80 kts sustained over a 20 minute period.  Coupled with higher gusts the force inclined the boat by 30 degrees at times during swirls.  As a result of our preparation, we emerged safe, exhilarated and positioned to rescue the crew of the sunken boat.   

Stock Market Crash - When???

In previous posts, I have commented on the potential for a correction in equities markets.

The following article by Jeremy Granthan is well worth reading.

Bracing Yourself for a Possible Near-Term Market Melt-up

I find myself in an interesting position for an investor from the value school. I recognize on one hand that this is one of the highest-priced markets in US history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.

Summary of my guesses (absolutely my personal views) (Grantham's view)

■ A melt-up or end-phase of a bubble within the next 6 months to 2 years is likely, i.e.,
over 50%.
■ If there is a melt-up, then the odds of a subsequent bubble break or melt-down are very, very high, i.e., over 90%.
■ If there is a market decline following a melt-up, it is quite likely to be a decline of some50% (see Appendix).
■ If such a decline takes place, I believe the market is very likely (over 2:1) to bounce back up way over the pre 1998 level of 15x, but likely a bit below the average trend of the last 20 years, as the trend slowly works its way back toward the old normal on my“Not with a Bang but a Whimper” flight path.4

A. Suggested action plan for everyone (Grantham's view)

■ What I would own is as much Emerging Market Equity as your career or business risk can tolerate, and some EAFE. I believe each of these, especially Emerging, has more potential than most think (as noted in my recent piece in GMO’s 3Q 2017 Letter).

B. For those individual investors willing to speculate5 (Grantham's view)

■ Consider a small hedge of some high-momentum stocks primarily in the US and possibly including a few of the obvious candidates in China. In previous great bubbles we have ended with sensational gains, both in speed and extent, from a decreasing number of favorites. This is the best possible hedge against the underperformance you will suffer if invested in a sensible relative-value portfolio in the event of a melt-up.

■ As is also true in Case A, if we have the accelerating rally that has typified previous blow-off phases, you should be ready to reduce equity exposure, ideally by a lot if you can stand it, when either the psychological signs become extreme, or when, after further considerable gain, the market convincingly stumbles. If you can’t cope with this thought and can’t develop and execute an exit strategy, then sit tight and ignore all this advice, except for an overweighting of Emerging. I certainly recognize that leaping out of declining markets is a completely unrealistic idea for large, illiquid institutions and nerve-wracking enough for even the toughest-minded individuals. In this sense you can treat this paper as an academic exercise… the musings of an old student of the market, who thinks he sees the signs of an impending melt-up that will be painful for value investors. Is it better to be warned and suffer than be surprised and suffer? At least when warned you can brace yourselves.