March 16, 2020 - Shear the Sheep or Skin the Sheep?Submitted by Alsworth Capital Management, LLC on March 16th, 2020
You are no doubt consuming the news like drinking from a fire hose. It is good to stay informed. However, I recommend taking frequent breaks and remembering the importance of walking outside and feeling the sun as often as is feasible. While we are learning what social distance rules to live by, we are fortunate in our ability to still interact with nature and stay connected through technology. We should not underestimate the importance of both.
As you know, the markets have been reacting quite severely to the coronavirus and the implications of shutting down large swaths of economic activity. The situation is fluid and unpredictable. Hardened prognostications about what is definitely going to happen are useless, if not dangerous to your emotional and financial health. I strongly recommend being skeptical of prophets and the comfort that comes with believing we can predict the future. It is unlikely that the impact of this crisis will be over in a month. It is also unlikely that all our corporations are going to go bankrupt and that we will need to resort to subsistence living. Reality is likely in between those extremes and the probability of any specific outcome along that pendulum line will only be clarified by time. We can take actions today to prepare for any outcome and adjust our actions based on the probability of outcomes along the way.
We have been cautious with our investment allocations for a number of years, based on the very high level of valuations and our recognition that unpredictable risks always exist. A normal level of risk was not priced into the market in 2019. An unpredictable crisis has now occurred, and the stock market has dropped to reflect this uncertainty. As of the day of this writing, if we ignore the coronavirus and go back to our models prior to the crisis, we are back to a reasonable valuation. However, from this point looking forward, we need to price in the likely impact of this new information and make some tough probability weighted decisions. We will not be 100% correct. We will not find the bottom and time it perfectly. That is a virtual guarantee. However, we can keep cool heads and react slowly and deliberately, in an effort to help your long-term position. So, the primary question is what to do with the stocks in your portfolio now?
I grew up with three older brothers and a younger sister in rural Allentown, NY. The boys were a labor pool for a local farmer, and he did everything he could to keep us busy and out of mischief. He was in his latter years as we were coming of age and he sort of adopted us as his grandkids. In addition to putting us to work, he would spend time with us, teaching us how to hunt, fish and buy antiques. He would also take us to local auctions, clam bakes and fairs. He often tried to pass his stories on to us, which usually came as funny parables. One of my favorite parables, which came up frequently, was a simple statement “you can shear a sheep and shear a sheep and shear a sheep…. but you can only skin ‘em once!” It has always stuck with me as a cogent moderating principal about keeping balance, eschewing greed and keeping your senses when you are fearful. Our decisions have consequences and we need to make them with a level head.
When we put together your portfolio, the most consequential decision is how much to put in stocks and how much to but on bonds. Every portfolio we manage, even the most conservative, has a minimum goal of keeping pace with inflation. If you hold a pile of money and don’t keep pace with inflation, the purchasing value of your money is just declining every day as it sits there. Traditionally, a 100% bond portfolio would have been priced to comfortably keep pace with inflation with the interest that it earns. Unfortunately, as a result of Federal Reserve policy decisions in response to the dot.com crisis and Great Recession, interest rates have been priced at or below inflation for quite some time. As such, we need to have at least some proportion in stocks to generate growth in the portfolio. Most investors need some level of “excess” growth in the portfolio to meet their living expenses as well, which means we must have a meaningful allocation to stocks. This has been an easy trade off in the last ten years, as the market had been on a relatively steady climb since 2009. In fact, in the last 6 years, the most common refrain I’ve heard from clients is “why don’t we have more in stocks?” Our approach has been to hold only as much in stocks as we need, then let the stock market do its thing and grow. We then rebalance the accounts to trim those gains and bring our portfolio back in line. As an example, a portfolio with a target of 50% stock and 50% bonds, would have seen the stock allocation rise to around 55% by the end of 2019, due to the fact that the value of the stock allocation rose faster than the bond allocation. We rebalanced portfolios in January to sell that excess growth and bring the stock allocation back down to target. This is shearing the sheep.
When the market is dropping and the news is all crisis all the time, it is understandable that we might want to cut all of our stocks out of the portfolio and put everything in cash. This is akin to killing the sheep and selling the hide. Once that decision is made, there is no going back. You will have to go out and buy a new lamb later and wait for it to grow to maturity. All the while, you are missing out on all those opportunities to shear the wool. We can’t predict the future. If you sell out now and wait to feel comfortable again to get back into the market, it is going to be too late. You will have missed out on the recovery and done lasting damage to your portfolio. My best advice is to know that we have been preparing you for risk. We have put you in a portfolio that we believe you could hold on to through bad markets. Your bond allocation is doing well during this market turmoil and we can sell those bonds to meet your withdrawals for a long time. In the meantime, we can let the stock market run its course and wait for the stocks you currently own to recover in value. We will make small incremental new purchases when stocks are cheap, which we believe will help your portfolio longer term.
Don’t kill the sheep. Shear and harvest the wool. This is winter, but spring is coming!
As always, please do not hesitate to call me. That is what I’m here for. My game plan is to keep my office open and continue with business as usual. I ask that we use email, phone calls and snail mail as much as possible to reduce the amount of physical interaction until further notice. Our office is paperless and cloud based, so we can operate from our homes or off-site location if needed.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman Gregory Research