By John Lunt, Lunt Capital
We are frequently asked if we think that financial markets will correct or sell off (note: corrections are typically defined as 10% declines and bear markets as 20% + declines). We do not know the exact timing of a market correction, but we certainly believe that corrections and bear markets will happen during the time horizons of most investors. Volatility is not an anomaly; it is a characteristic of financial markets. Investors perceive that policy risk is elevated due to increased uncertainty surrounding monetary policy, tax policy, healthcare policy, and trade policy. Layer on concerns about market valuations and geopolitical tensions, and fears about a potential market correction are understandable. As an investor, it is time to review your market correction checklist.
As with any investment decisions, concerns about risk must be balanced with opportunities for growth. The potential for a market correction cannot preclude the potential for a continued market rally. Valuations ultimately matter, but valuations may be poor timing mechanisms. Policy changes may spur growth that justifies current valuations. Whether a correction is imminent or distant, an investor’s market correction checklist should include the following questions:
Is the investor’s time frame consistent with the portfolio allocation? We believe in market beta over the long-term. There may be compelling reasons that market beta for the next decade may deliver returns below the historical average, but we still believe that beta will deliver positive returns. The time frame matters, because a market correction (or worse) is more problematic for money needed in the next five years than it is for money needed in 20 years. If 20-year money could be protected from potentially harmful investment mistakes, there would be less need to worry about periodic declines. The investment journey matters, and investors without a plan or perspective are particularly susceptible to market emotion and investment mistakes during corrections and bear markets. A shorter investment horizon demands a more defensive allocation that attempts to protect against steep portfolio losses.
How would the portfolio (and each allocation, strategy, and position) potentially respond to a 10% or 20% decline in U.S. Equities? This is a question that can’t be answered with perfect specificity, but a general understanding is valuable. The trigger for the market decline is relevant—is it domestically led or foreign led? Is it triggered by Central Bank actions or by a geopolitical crisis? Is it politically triggered or due to a general economic decline? The investment industry rightfully highlights that past performance is no indication of future returns. However, performance during previous corrections can provide context about allocation characteristics. An understanding of both correlations (directional movements of investments) and beta (magnitude of movement vs. a benchmark) become essential to this analysis. Remember, investment correlations may be higher during a moment of market crisis, but investment differences are appreciated in the subsequent days, weeks, and months.
Have you made specific allocation or strategy decisions that would lead you to expect the portfolio to decline more or less than the market? For example, a fixed income allocation heavy in high yield may suffer a larger decline during a market correction than an allocation focused on investment grade corporate bonds and U.S. Treasuries. An active strategy that attempts to reduce market exposure during a correction offers the potential to cushion portfolio losses while a passive, fully-invested approach may capture the complete decline. It is important to evaluate the potential costs of defensive or risk-managed allocations during a market rally. Do the potential benefits in dollars and peace of mind warrant the potential opportunity costs?