Watch Out for the Second Shot

As you might imagine, it has been a pretty intense five months as an investment advisor representative.  Oddly enough, I’m feeling old these days, despite only being forty-four, as I remember the many times I’ve experienced bear markets in my career.  At each of the past bear markets, I recall stories from other veteran advisors about how this time was unprecedented in their careers. The timing of my career has been interesting.  My first job out of graduate school was as a co-manager on a sizable portfolio at the absolute peak of the dot.com bubble in 2001.  I left that job to start my own business right before the Great Recession hit in 2008.  Over the next fourteen years, the market recovered and has generally been in a bull market, with a massive blip in 2020, as the pandemic hit.  The entirety of my twenty-one year experience as an investment manager has been living with the great experiment of zero or near zero interest rates, as manipulated by the Federal Reserve.  Coupled with that, has been constant fiscal stimulus programs, unfunded tax cuts and corporate bailouts with no serious attempts to address our exploding national debt.  All of these can be justified in trying to prevent economic pain and they shared political support from both parties.  None of these are natural maneuvers in a properly functioning free market system.  All of these have unintended consequences.  In the aggregate, they have had the effect of reducing investor’s perception of risk and they have prodded investors into paying higher and higher prices for a given expected future income stream.  This is true of housing prices, car prices, college education prices and prices for stocks and bonds.  Perceptions of risk are changing quickly, for a laundry list of reasons and the stock market is on the cusp of a bear market (20%+ decline) as I write this letter.  It has been jarring to many investors that haven’t lived through bear markets before.  It has also been jarring to seasoned investors that have been lulled into calm by seemingly perpetual positive returns.  A free market for stocks represents differing opinions about expected future investment income, as well as reactions to new data that is constantly streaming in.  This creates volatility with up and down adjustments to estimates of “fair value.”  Until this year, we just haven’t seen much of the down part, so we need to recalibrate our emotional response to the cold mathematics of markets. 

Having a glass of wine with my wife Jacqueline, I was recently pontificating about bear markets and emotional responses.  She made an interesting analogy.  She reminded me of a scene in the classic children’s movie, Bambi, where pheasant birds are nestled in grass cover as a bird hunter is walking through the field.  One of the birds is freaking out and panicking, while the other birds are telling her to be quiet and calm down.  She paces back and forth, then shouts “I just can’t take this anymore” as she flies out of the grass and toward the safety of the sky.  Several seconds later, there is a loud bang and a thump, as she falls to the ground.  I personally did not remember this scene, but it stuck with Jacqueline as a significant childhood memory.  It seems like a fitting analogy.  The time to make a plan is before the hunter enters the field and while we can think clearly.  The next step is to stick to our plan despite the gripping fear.  We may want to shift our position in the grass, but we need to keep our cool. 

We have been concerned about high valuations even before the pandemic hit and nothing fundamentally altered this viewpoint during all the crazy dislocations and temporary shifts caused by the pandemic.  We had previously added a position in Gold and steadily added to it during periods of price weakness.  We shifted the stock portfolio toward investments that have lower valuations and steadily away from the high valuation US growth sector.  In the first quarter of this year, we completely sold out of our small remaining US large growth position, as the market sentiment started to turn negative.  We have maintained less exposure to stocks overall relative to our strategic models due to high valuations.  This has been a drag on relative performance as the stock market has rewarded high valuation stocks over the last three years.  We are starting to see some relative improvement versus our strategic model, but during panic driven market declines, everything sells off, so I don’t expect to see much differentiation until markets settle down.  We have also been taking advantage of steep declines to do some tax loss selling.  We have sold positions in taxable accounts that are trading at a loss, while reinvesting in similar positions, to maintain the exposure.  After 30 days, we can switch back the positions to book tax losses, which can be quite useful when markets recover, and we need to sell off positions that have capital gains.  These tax losses can be banked and carried forward forever to offset future capital gains and reduce your future tax liability.  I expect we will be doing more of this type of tax loss trading throughout the year, as this is likely to continue to be a volatile market.  It is becoming increasingly likely that we may see a period of elevated inflation, coupled with a weakening economy, which can be described as “stagflation.”  I expect Gold to be beneficial if this comes to fruition.  I’m also looking at shifting a portion of the portfolio toward active professional managers that invest in commodity and commercial real estate markets.  During valuation driven bear markets in the past, we have often had very powerful snap back “buy the dip” recoveries.  If that occurs this time, I intend to use those opportunities to make the gradual shifts to add this new position. 

As always, I recommend that you stick to your plan and resist the urge to fly to the perception of safety of cash.  Even if the first shot misses, you need to find your way back to the original plan at the right time.  It is much harder to evade the second shot, once you are in the open skies.  

Please call or email me anytime if you want to discuss your situation or the portfolio in general.  If you have new large cash withdrawal needs over the next two years, we should make a plan to meet those needs during volatile markets to minimize the need to sell positions that are trading down in price. 

Cordially,

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}

_{All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.}

_{The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.}

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