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?
How will the active fund manager or the passive index rules respond during a market correction? Investors should review the process that each fund or ETF follows in the management of its investments. Are decisions based on experience and discretion or are decisions determined by unbendable rules? What triggers changes in allocations or holdings? Does a price decline of a certain magnitude trigger a change or does change only occur at specific intervals? It is not only essential to understand a manager’s or an index’s approach to reducing or changing market risk and exposure, but also to comprehend how risk and exposure is reintroduced.
How will the financial advisor respond during a market correction? Financial advisors have to ask themselves if each portfolio, allocation, and strategy matches the time horizon, financial capacity, and risk tolerance of each client. Most financial advisors hold the keys to a client’s asset allocation. This is the most significant key to ultimately meeting a client’s financial objectives. Is the advisor expected to make the decisions about dynamically increasing or decreasing market exposure? Is this decision outsourced to fund managers or ETFs? For some advisors, clients expect the allocation to change as markets change. If so, what are the rules and procedures for making changes? For other advisors, client asset allocations are set and are not expected to change, even in the face of significant market decline. How will advisors help themselves and clients avoid behavioral mistakes in the teeth of a correction? Will the advisor be willing to stand firm in the face of concerned client? In some cases, financial advisors anticipate that a client will be unhappy with the performance of the portfolio. In these cases, advisors may attempt to preempt these concerns and suggest unnecessary changes.
Is each position the right size within the portfolio? Position sizing is one of the most important roles that a financial advisor can play for a client. For example, an advisor may have a 30% strategic allocation to an equity growth strategy. After a 10%-20% decline, would the advisor or client reduce the exposure to 15%? If so, it would be better to give the equity growth strategy an allocation of 15% as the initial allocation and live through the correction or bear market without making changes. A strategic allocation is different from a dynamic or tactical allocation that potentially reduces exposure as the position declines. Dynamic strategies will be susceptible to false alarms. Will the advisor allow the strategy to work as designed, despite getting defensive more often than is ultimately necessary?
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How will the investor or client respond during a market correction? Can the client live through a market correction (or worse) without demanding changes? The behavioral mistakes associated with clients strategically moving from an aggressive risk profile during market rallies to a conservative risk profile during market declines is a quick path to wealth destruction. Does the client have appropriate return assumptions and realistic risk management expectations? Defensive strategies and asset allocations have the potential to reduce or cushion declines, but they rarely eliminate losses during market corrections and bear markets. Clear, realistic communication between advisor and client is a common theme in the successful navigation of market rallies and declines.
Whether a correction happens soon or is still years away, it is time to review your market correction checklist. In our opinion, the ideal investment allocation is the one that the advisor and client can live through.