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RESPIRE WEALTH MANAGEMENT, LLC

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The melt up before the melt down: Should you sell?

October 12, 2017

 

Clients are asking me about the “market melt up.” Bear with me on this one. The next two sentences are sticky for a reason. I’m going to tell you what you need to know. But, I’m also going to tell you what you need to know to understand what you need to know. That is, I’m going to give some explanations in very lay terms so that you can catch the most important points.

 

As the saying goes: buy low and sell high. Or, as Warren Buffet famously said, we should be “fearful when others are greedy and greedy when others are fearful.” Let’s examine what we know about the potential for a major decline, bull markets, missing the best days of the market, and how market declines affect our investment accounts. There will be a focus on the impact of declining investment prices in retirement savings accounts.

 

I’m going to start by giving us a foundation for the discussion: When I talk about declining stock investments, I’m talking about the falling share prices of diversified investments of a reasonable quality. That is, perhaps an allocation in an index such as the S&P 500 or a large cap stock fund. I’m not talking about penny stocks or poor-quality investments purchased on speculation.

 

No one can predict a decline with 100% accuracy. And, even when they can somewhat predict it, this can only be done within a broad time range. Selling too early can be okay for some investors. There’s a time and a reason to do this. However, selling just because an investor anticipates a decline can cause the investor to miss out on valuable returns if stock prices continue to rise beyond the point where he or she sold out of stocks.

 

What is correlation and what are asset classes?

 

One of the major indicators that I started discussing in my seminars a little less than a year ago is that we are starting to see a high level of correlation between asset classes. Asset classes are different kinds of investments. Stocks are one asset class. Other asset classes would be fixed income (bonds), precious metals, real estate, commodities (orange juice, soy beans, bacon, cotton, etc.), and a whole range of other investment types. Correlation is the measure of how assets values are rising or falling versus each other. A well-diversified asset allocation strategy will measure correlation of different holdings, and will purchase those with low correlations—the ones that move in a different direction to one another or even have an inverse relationship—in order to mitigate risk within the strategy. According to an article in The Economist, many asset prices are rising in a bull market trend together. They are highly correlated. I’ve been saying this was happening for a while, and now The Economist is sending out a message of pause. Finally. Let me add that when I’ve discussed this, I have not discussed it in a way that raises red flags or alarm bells. It’s important not to be alarmist. High correlation of asset classes can indicate that a correction (a market decline) is coming, but the signal can exist up to two years in advance, and sometimes exists even when no correction occurs at all. It’s when the signal is coupled with other factors that analysts begin to worry.

 

What is volume? And, if all stock transactions require a buyer and a seller why do we call it a sell off?

 

Another factor I like to consider when anticipating a changing trend in the market is volume of trades. If you’ve ever watched CNBC or Fox Business or Bloomberg then you’ve seen the prices of stocks and the indices flash red or green. We all know that green means the prices are going up and red means the prices are going down. Prices tend to decline within a day, week, or month when investors are selling. But then they have to have someone to buy, right? So, how do you know? When investors decide it’s not desirable to hold an investment and they want to get rid of it they place an “offer” to sell at a price. If they want to get rid of it bad enough they may have to offer it at a lower price to make it look attractive to a would-be buyer. Sell-offs are driven by investors offering their shares of stock at lower prices to make them more attractive to buyers. On the flip side of that, when investors decide that an investment is desirable and they want to buy it, they’ll put out bids to purchase shares of stock and continue raising that bid until someone who owns the shares decides an attractive price is being offered. When the market is going up, buyers are willing to pay a higher price because there is perceived value to that investment. Sometimes the perceived value in buying and selling stock is backed by strong financial data that indicates there is either real upside potential or a real problem that will cause share prices of companies to be worth less money than they were before. Other times, the perceived value in buying or selling is emotional and not backed by strong financial data.

 

There’s a concept, “irrational exuberance,” that applies to what we’re seeing in the stock market right now. Irrational Exuberance is also the title of a book by Robert Shiller and we’ll discuss him again in a moment. Volume measures the number of trades placed in any direction. The market will tick up, green, or tick down, red, whether investors are trading 1,000 shares or 1,000,000 shares. It just depends on the direction that most of them are going over a specified time period. When volume is high, there’s a general indication that big money movers are driving the market. Those are people in-the-know: fund managers, institutional buyers, people with a lot of money to throw around. When volume is low there’s a general indication that smaller money is driving the market prices. These are retail investors, the general public, people with brokerage accounts. Let’s look at a visual of volume and how it relates to the S&P 500. It’s very difficult to get a picture of volume on the index itself. So, I’m going to use a fund whose symbol is SPY. You can view this fund versus the S&P 500 at Yahoo Finance, Google Finance, or the source of your choice and see that it tracks almost perfectly if you need some proof. I like the charts at investing.com and zacks.com because they have nice bold colors. You’ll notice I mix my chart sources depending on what I’m trying to show you so I can give you the best visuals I can access. I used investing.com for this one.

 

 

 

The blue mountain is the S&P 500 going up from the start of the recovery to today. The bars at the bottom are monthly volume. Red means prices were going mostly down and green means prices were going mostly up. The height of the bar indicates the number of shares traded, the volume itself. The line that goes across the top of these is a 20-month-average volume line to smooth the trend. Notice that volume has gone down significantly in recent months, yet the stock market continues to rise to new record highs. These are retail investors. Small money is diving in because the water feels and looks nice to them. Also, they’ve seen a lot of other people winning with big gains and they’re tired of sitting on the sidelines.

 

Ghosts of markets passed or past:

 

Here’s a classic add from nearly 20 years ago. In it, a tow truck driver explains how he’s made quite a haul by investing in stocks online. Not long after this the tech bubble burst. An add like this would never fly these days. Can you imagine a brokerage advertising that you could make enough to own your own country? Nope. But, the market advertises itself by reaching new historical highs. Please enjoy this commercial:

 

 

 

 

 

 

 

 

 

 

What is volatility and why hasn’t the market been responding to headlines?

 

We’ve established that the market has been going up on low volume. The market also normally experiences higher volatility. That’s the movement up and down that people don’t like. This week we had one of the lowest volatility days in the history of the US stock market. In other words, it’s just going up. Volatility this low makes me just as uneasy as abnormally high volatility.

 

There’s a reason why it’s bad for the stock market to go straight up. It means there’s no rational buying. It’s all emotional. Call it “irrational exhuberance.” Remember that? Robert Schiller, who wrote a book by the same name, is a Nobel Prize winner. He feels the same way I feel. Twelve month price to earnings ratios and some of the other measurements investors use don’t tell us much of anything. In my newsletter, a couple of weeks ago, I mentioned that Robert Shiller had made a public statement that may have flown under the radar for a lot of investors. But, in the world of advisors and asset managers, there was quite a bit of buzz about it. He published his thoughts in Project Syndicate and made an interesting parallel between what we’re seeing now and what happened before the last 13 “bear markets” (unofficially, losses of 20% or more). You can email me to subscribe to the newsletter if you want to check these out and get a heads up on investment buzz.

 

What we’re seeing right now is greed. CNN has a Fear & Greed Index. It uses several different factors to measure investor sentiment in the market. Check it out. The scale goes to 100. When I started working on this piece it was at 95. It’s still in the range considered “extreme greed.” Remember that we should “be fearful when others are greedy?” Why is that? It means the market will crest, the bubble will burst, what goes up must come down. In case you didn’t read my piece on neuroeconomics and behavioral finance, here’s a handy market emotion visual that I made.

 

 The point where we enter the market with the greatest level of risk is when we buy when investors are feeling “thrilled” or “elated.” The point where we enter the market with the greatest level of opportunity is when we buy when investors are feeling “panicked” or “despondent.”

 

 

Melt ups followed by melt downs:

 

There are several possibilities here. We could be in a situation like the 1990s, and we could keep going up, much higher. After all, unemployment is still very low, people are still spending and buying houses. The economy seems to be fine. But, we may find that stocks are overbought. People have paid too much for them. In that case, we could go through a very normal correction soon. That would be a loss of 10-20%, possibly more. Or, it could go a little deeper, and it could happen really fast. The last possibility is something that’s become a little buzz-y lately: a melt up. What the hell is a melt up? It’s what happens when everyone in the market feels really good and they just keep buying because they like the feeling of it. There’s no rhyme or reason—no data to back the prices of stocks. It just moves up, ignores signals, ignores headlines. Then, the market becomes very expensive.

 

What happens after a market melt up? A market meltdown. It’s a deep dive of stock prices driven deeper by sell offs in funds and margin calls. Options trading can also amplify a sell off, and are the instrument used to indicate volatility in the CBOE Volatility Index . . . but that’s more than you probably need know at this moment.  I think that even for the most lay person reading this, it’s easy to understand what a sell off in funds might be, or at least you can imagine. What you might not understand is a margin call. We’ll cover both anyway.

 

Starting with sell offs in funds: Do you remember what I said about selling? If the trend is selling then investors will offer to sell the shares they own at lower prices to make them more attractive. Funds own lots of shares of lots of different things. Sometimes they own multiple asset classes. If investors sell enough of a fund then the fund manager may have to start selling off large positions in order to meet demands for cash or to rebalance the fund to bring it back in line with its investment policy. Thus, an even larger volume of shares will be offered for sale at lower prices, creating tall red volume bars all over charts. The fact that flows to index funds and ETFs have increased will actually amplify sell offs as entire indices worth of holdings have to be unloaded to create cash for mutual fund investors or to rebalance positions in all index-oriented low-cost funds.

 

Margin is leverage (or debt). Let’s say you have a $1,000,000 portfolio of stocks. If you have margin, then it means you might have a line of credit worth 50% of the portfolio. So, you’d have $500,000 available to you. If you use it as leverage, then you might buy more of the same investments or some different investments. If you use it to buy the same investments, then margin could allow you to own $1,500,000 worth of the investment portfolio. You’d pay interest on your margin. So some investors choose to keep some cash on hand to service their margin and pay the interest due. Gains on investments made from margin are the investors’ to keep. So, it serves as a lever—it leverages the amount invested and therefor the returns on the investment portfolio. It also leverages losses, as the investor is responsible for losses on investments they’ve purchased on margin. Here’s some math:

 

Scenario 1, Gains in non-margin and margin accounts:

 

Investor A has an account without margin worth $1,000,000. He leaves $500,000 in cash and invests $500,000 in a stock portfolio. His stocks have experienced a 50% gain over the last four years. His stock portfolio is now worth $750,000. He has a total of $1,250,000.

 

Investor B has an account worth $1,000,000. She leaves $500,000 in cash and invests $500,000 in a stock portfolio. She also uses $500,000 of margin to invest in the same stock portfolio. She has 50% equity in the $1,000,000 total investment she has made. Over four years she experiences a 50% gain. Her stock portfolio is now worth $1,500,000. She sells and pays back the $500,000 in margin but keeps all the gains. She now has the $500,000 she initially left in cash, the $500,000 she invested in stocks and the $500,000 gain on investments, a total of $1,500,000.

 

Scenario 2, Losses in non-margin and margin accounts:

 

Investor A has an account without margin worth $1,000,000. She leaves $500,000 in cash and invests $500,000 in a stock portfolio. Her stocks have experienced a 50% loss over the last year and a half. Her stock portfolio is now worth $250,000. She has a total of $750,000.

 

Investor B has an account with margin worth $1,000,000. He leaves $500,000 in cash and invests $500,000 in a stock portfolio. He also uses $500,000 of margin to invest in the same stock portfolio. He has 50% equity in the $1,000,000 total investment he has made. Over a year and a half his portfolio experiences a 50% loss. His stock portfolio is now worth $500,000. He owes all of that back to repay the margin he used and lost. He only has his cash left. He has a total of $500,000.

 

Margin can also be used for other purposes. It’s just a line of credit. So, investors can even use it like cash and write checks off of it. They’ll sometimes do this to increase the time horizon on their investments, allowing them to use cash without having to sell at inopportune times when the market is down.

 

However, in order to guaranty that margin can be serviced—paid back—investors must maintain at least 25% equity. So, if they write too many checks on margin or invest too little of their own money and then experience swift market declines, such as in the Global Financial Crisis or the Tech Bubble, they’re likely to reach the level where they have too little equity. There will be a margin call. The lender will ask the investor to bring their equity in the account back up above the maintenance level. Investments will have to be sold or the investor will have to come up with cash to pay off the margin.

 

During sell offs, or market melt downs, margin calls result in rapid selling of investments. And, you’ll recall that when someone is selling at the same time as everyone else, they’ll have to price their offer to sell at an attractive price, a lower price, in order to get a buyer. This pushes prices down. It accelerates the sell off. Then, there’s a kind of bumpy downhill road that we travel as margin calls, selling in funds, and general fear from retail investors, cause prices to plummet below accurate valuations. That is, below what they’re really worth. They’re on sale.

 

So, a market melt up is when the prices rise rapidly for no apparent reason and without fundamental data to back the stock prices. It is followed by a meltdown that begins with a simple correction of values (a decline, but a harmless one), but then results in a deep dive below the correct market values (which takes the breath away and results in a lot of pain for emotional or ill-advised investors).

 

Margin isn’t permitted in retirement accounts. However, in retirement accounts, investors often own investments that have other leverage built into them. Remember margin is leverage, but not all leverage is margin. Each layer of leverage can double upside potential and more than double the downside risk. Remember that retail investors are limited to 50% margin. That’s a maximum. Most investors are leveraged at 1:2 or 1:1. Lehman Brothers had a leverage ratio of over 30:1. When institutions and investors have layers upon layers of leverage the effect is astronomically terrible. I can’t think of a better adverb there. To the average person the result of the global financial crisis was a bad stock market, some people bought houses they couldn’t afford, and the banks got bailed out. Yes, the banks made terrible mistakes, but if the banks hadn’t been bailed out we would not have had jobs to go to anymore, groceries on the shelves in our grocery stores, fuel at the pump, or maybe lights to turn on. At least, a large percentage of us would have been without those things. Bush 43 had to make all of the financials take the bail outs. Some of them didn’t want or need the money. However, if the headline in the news the next day had been that only two or three had taken the bail outs, there would have been a run on those and the financial crisis could have gone much deeper. No matter where you stand in politics, that was a tough call and would have been a tough call for any President to make.

 

These factors together will result in a meltdown, but it is important that you don’t get caught up in the frenzy. That’s not to say you should sell. It means you shouldn’t contribute to the downside from selling and I’ll explain why in a moment.

 

The US stock market won’t go to zero:

 

A person who turned 18 years old in 2008 and became old enough to open an investment account is now 26 or 27. Let’s say that most people start investing at about 21 at the earliest, when they are eligible for their company retirement accounts. Those people would be turning 30 this year. Let’s look at annual total returns (gains and dividends) for the S&P 500 since then:

 

2008      -37%

2009      26.46%

2010      15.06%

2011      2.11%

2012      16%

2013      32.39%

2014      13.69%

2015      1.38%

2016      11.96%

YTD       15.89%

 

It’s been almost 9 years since anyone in America has had a year that ended with negative returns. If an investor had purchased the S&P 500 in the period of greed at the top in the fall of 2007, experienced the full decline without selling, and held it, he or she would have doubled the initial investment as of September 2017. According to the rule of 72 (I'm going to use that rule in another article later this month) that’s a 7.2% average return annually. The market declined over 55% from the top in 2007 to the bottom in 2009. You’ll find that I remind people about that a lot. There’s a reason. It’s that, in spite of how the decline felt, the market was not going to go to zero. If it had, we would not be able to turn on our lights, drive our cars, or go to the grocery store. We would not have investment accounts to worry about or employers. The entire economy would have crumbled. No one was going to let that happen.

 

If a person sold at the bottom of the market because he or she felt scarred by the decline and remained in cash, what was the likelihood that cash was going to rebound with the market? How much does your savings account pay? Yet, so many people sold, locking in huge losses right at the bottom. Maybe they didn’t move to cash. Let’s just say they went to a bond portfolio. Here’s what investment grade corporate bond fund LQD did versus the S&P 500 from the bottom to now. Source: Google Finance via Sixx. The red line represents the S&P 500, and as you can see your investment would have more than tripled from the bottom. The blue line represents the bond fund. I think this speaks for itself. If you had taken a more conservative position at the bottom you would not have enjoyed the upside.

 

Does that mean you have to buy and hold?

 

No, it doesn’t. There are several strategies that are good for different types of investors based on risk tolerance and age and time horizon.

 

First, let’s consider risk tolerance. Risk tolerance is generally measured on a scale of conservative to aggressive. You can complete this questionnaire to find out what an allocation looks like based on your risk tolerance. If you are a naturally conservative investor, you may have to forego upside. There’s a risk reward trade off. But, if you’re losing sleep and at risk of selling at inopportune times then you can consider the upside you’ve missed an insurance premium that keeps you from losing by selling at the bottom. If you’re an aggressive investor then you need to determine if you’re aggressive all the time or only when the market is going up. If you’re 30 years old and have no idea what a market meltdown feels like then you may not really know your risk tolerance. I run across a lot of people who only want to participate in upside and they expect some crystal ball that prevents them from experiencing the downside. However, that doesn’t really exist. So, there’s some risk that has to be accepted. It’s not all doom and gloom though. Respire uses tactical rules to determine when to get in and out of investments. So, investors still experience normal market movements, but the rules trigger removal of certain investments when the market goes into meltdown mode.

 

The other consideration is age and time horizon. If you’re in your 30s and the only investments you have are for retirement then you probably want to be more concerned with missing out on upside than protecting against downside. Your contributions in your 401k are dollar cost averaging. An exercise I do with clients illustrates how beneficial market volatility is when you’re dollar cost averaging into a retirement account. Mike decides to invest $200 a month. There are not costs or other considerations in an effort to keep this simple. He’s buying imaginary investment X. Investment X is worth $40 in month 1 and he buys 5 shares. That’s $200/$40=5. In month 2, X is worth $20 per share. His initial investment is down 50% but he buys more anyway. He gets 10 shares. That’s $200/$20=10. In month 3 the price of X is back up to $40 per share. He gets 5 more shares. Mike now has 5+10+5=20 shares at $40 per share. That’s $800 worth of investment X, but he only invested $600. Yet, investment X never went above his initial purchase price. That’s because Mike made money on the dip. This is great for someone who has a longer time horizon.

 

People a few years out from retirement don’t want to experience a 50% decline in their investments. They've been saving 30 years or more. The best option is to go ahead and take a more conservative allocation or to decide that they’ll be flexible with their retirement date and wait for the market to bounce back. Taking a more conservative allocation prior to a market downturn or meltdown will prevent the need to wait to retire. However, it will also result in missing out on upside. But, again, that upside missed is like paying a premium for an insurance policy. Employer 401ks or retirement accounts typically have two types of investment money that have to be changed when altering an investment strategy. The plans break money into investment allocation and investment direction. Changing investment allocation changes the way money already in the plan is invested. Changing investment direction changes the way new money coming in from paycheck deferrals is allocated. They are independent from each other. People planning on retiring soon or looking to play catch up very quickly should consider the following strategy or consult an advisor about using this strategy. The retirement saver would change his or her investment allocation to a more conservative strategy to make sure the whole retirement account doesn’t participate in the downturn. Then, he or she would wait until the market is in steep decline and alter his or her investment direction so that new money arriving in the plan is buying the dip in prices—taking advantage of the fire sale.

 

We don’t ever want to miss out on upside in investment accounts simply because the market might go down. You know that if you decide to sell because you “think” the market is going to go down, it will do the opposite just to spite you. However, if you have assets that need to be preserved for retirement that’s planned in the next five years then a strategy like this might be suitable for you. You might need to forego that upside and take advantage of the prices when the market does finally meltdown.

 

If you’d like to talk more about getting advice on what you should be buying or selling in your own accounts, or to learn about Respire’s tactical asset allocation strategies, call 832-915-0575 or email info@respirewealth.com.

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