Risky Waters and Opportune Waves

Yesterday’s hefty selling in the stock market may have shocked the perma bulls, but it should come as no surprise to strategic-minded investors. The writing has been on the wall for some time now, economically and financially speaking, as your editor has been pointing out for the better part of the past year.

The challenge, as always, is keeping the long term in focus without getting distracted by the day-to-day tactical issues that emit conflicting signals. Rest assured, much of the financial industry is dedicated to analyzing the here and now, leaving the strategic view up for grabs. If the majority of investors aren’t watching the broader trends, that’s partly human nature; it’s also a byproduct of the instant-gratification culture that’s become part and parcel of the 21st century finance.

But big-picture trends wait for no man. Even so, let’s no kid ourselves: identifying those trends amid the chaos of the daily noise is difficult and prone to error. That’s one reason why we always favor broad diversification across all the major asset classes. Yet we’re also inclined to tweak the weightings from time to time if the valuations enhance our conviction that the future is a bit less foggy in some respects than usual.

Most of the time, the clues are a blur and so we often lean toward a relatively passive asset allocation. But sometimes the financial gods give throw us a bone, as they seemed to be doing back in early 2007. Stock market volatility back in those halcyon days, we observed at the time, had fallen to unusually low levels. Since volatility can’t drop to zero, along with an understanding of volatility history, suggested that the trend would soon reverse and so volatility would rise. In turn, the five-year bull market in equities was set for turbulence.

There were other signs of trouble as well, some of which we wrote about. Low yields, for example. Another clue: all the major asset classes had been in multi-year bull markets at the time, suggesting that something had to give.

The point is that a number of indicators were speaking volumes as 2007 rolled. The cycle was changing, and it was time to prepare for something other than bull markets in everything.

Granted, your editor has consciously decided to err on the side of caution since then, and so our various warnings over time have tended to be early. For the skilled trader, who’s proficient at extracting profits (after taxes and fees) from the short-term twists and turns, our counsel has been of limited value and has probably come at a steep opportunity cost. But for the strategic-minded investor with limited, if any, tactical talent–i.e., yours truly–erring on the side of caution has worked well. Having slowly but consistently raised cash over the past 24 months, along with tweaking asset allocations here and there, we’ve managed to minimize the damage to our portfolio.

The goal is sidestep losses in bear markets and grab a fair share of the upside action in bull markets. Easier said than done, but our ability at pursuing that ideal has improved with time.

As always, the question is: Now what? In search of an answer, let’s explore some context. That starts with speculating that yesterday’s market action indicates that the crowd is showing signs of capitulation. Fear is nigh, with greed running for cover. We’d like to see more of that before making dramatic shifts in asset allocation.

Meantime, it’s time to nibble at the opportunities. The S&P 500 remains in a downtrend, although some thought otherwise in the March-to-May bounce. But a review suggests otherwise, supported by yesterday’s selling. The immediate question is whether U.S. stocks will dip below March’s low, which is the trough for the current cycle. For the moment, we’re within shouting distance of that trough, and breaching it on the downside would convince us to begin in earnest to redeploying fresh capital to equities, albeit slowly so as to diversify new investments over time and hedge the risk of even further declines.

In fact, other asset classes are looking increasingly attractive by virtue of their declines. High-yield bonds, for instance, have taken a beating recently. The iShares iBoxx $ High Yield ETF is near a new low for this cycle. As of yesterday’s close, the ETF’s annualized yield (using the last payout) is just over 8%. That’s a roughly 400-basis-point spread over the 10-year Treasury. Middling, although another leg down for the ETF holds out the promise for truly attractive valuations.

The same can be said for REITs, which have also been pounded lately. The Vanguard REIT ETF (VNQ) closed yesterday at its lowest since March. Accordingly, its yield is up. Based on the last dividend payment, the annualized yield for this REIT ETF is 5.4%.

It stands to reason that lower prices equate with higher expected return. As a result, strategic-minded investors should be increasingly focused on asset classes when they’re correcting. It’s not rocket science, but it’s not easy, either. And there’s always the danger of being too early. But that’s the nature of risk, and the associated gains. If it was clear what was coming, there’d be no risk premium. But the prospect of a risk premium implies that loss is possible too.

So, yes, we’re getting interested in certain asset classes. But we’re staying humble, too. These are the times that try investors’ souls. With a little common sense, it may also be a time for laying the groundwork for robust performance in the years ahead.

Originally posted at The Capital Spectator and reproduced here with the author’s permission.