When the Titanic left port on its maiden voyage, people believed the great ship was unsinkable. They were so sure that they only carried 20 lifeboats instead of the full complement of 64. Even after the ship struck the iceberg, passengers continued to party on thinking there was plenty of time to head for the lifeboats if, in fact, the ship was in trouble. Many investors often make the same mistake by thinking they can stay at the bull market party to capture all of the bull’s returns because there will be plenty of time to exit before a bear market begins.
Market pundits and the media lauding the length of this bull market trend as the “longest ever” are stoking investor “FOMO” (fear of missing out) on returns. As the markets have hit successive new highs over the past few years, it has made investing look easy. When memories of past bear market losses fade, investors forget about the pain they endured and recklessly chase returns as the markets move higher. Mutual funds’ cash holdings are at a low point and retail investors own a higher percentage of stocks than ever before: sure signs of speculation.
By the way, FOMO is just a polite characterization of “investor greed” which can cloud reasonable judgement and lead to poor investment decisions and large losses. If you listen carefully, as I do, echoes of bear markets past provide a scary reminder about just how tough investing can be. It seems every time the pendulum of investor emotion swings to an extreme, it is time to check your fully invested stock bets and head for the lifeboats.
The Investing Lifeboats
#1 Get Defensive
The first lifeboat for investor portfolios is a pivot away from growth and momentum stocks to a more defensive allocation by adding higher yielding dividend stocks. Dividends can offer a source of return not dependent on market price trends and tend to be less volatile to the downside. While they have underperformed the growth and momentum stocks over the past few years, in the long run they have been a smarter move over stocks that don’t pay a dividend.
#2 Raise Cash to Protect Capital
The next lifeboat would involve hedging or raising cash to actively reduce risk and protect capital. We believe the biggest win an investor can have is to curb bear market losses which can, in turn, preserve capital and their portfolio’s ability to compound effectively.
Retirees Need to Chart Their Course
The current bull market could actually end up hurting many retirees who have experienced nothing but gains over the past few years. They have forgotten their oaths to never put their capital and retirement income at risk again, after the brutal losses suffered in the last bear market. At the same time, pundits are warning of an impending bear market and potential financial crisis within the next 24 months. FOMO has investors chasing returns at a time when they should begin looking to begin seeking protection in investing lifeboats.
I imagine passengers on the Titanic thought they could enjoy the party a little longer too. Many investors don’t realize that a sharp run up in market returns like we have experienced over the last few years can limit future return potential severely. Today, aging investors are much more likely to experience a steep correction than significant additional return. For retirees seeking to withdraw income from their accounts, a bear market correction will pose a major problem as investors may be forced to sell more and more shares as prices fall to meet income needs. Any significant drop in portfolio value can unleash compound liquidation and may damage a portfolio enough to cause complete failure.
Navigating the Current Environment
With the pitch of speculative frenzy rising, investors have routinely shrugged off trade worries and Fed rate hikes, focusing instead on strong earnings and rising GDP growth. Yet any negative developments on earnings or the strength of the economy could dictate a change in investor psychology and market direction faster than you might believe. We know from past experience that investing is never easy, and bear markets tend to be the painful reminder that causes recent gains and investor capital to disappear.
With market leadership and investor capital crowding into a handful of “Goldilocks” tech stocks, it reminds me of the tech bubble of the late 1990s. Back then, investors came to believe that the elongated bull market trend might last forever, even in the face of nine successive Fed rate hikes. These hikes were enough to end the longest economic expansion on record and the biggest bull market of all time. Once again in 2006-2008 the Fed raised rates, this time they hiked rates eleven times tipping off the next bear market. September’s Fed rate hike was number eight in this tightening cycle and they are forecasting at least four more, with the next likely to drop in December.
We have already seen mortgage origination and housing construction weaken. And we have also noted an increase in the number of companies providing lower forward guidance than street expectations. Both are warning signs that should not be ignored. Early in my career in the 1980s, I was lucky enough to hear a noted economist say that smart investors recognize late-stage bull market risks and leave chasing the last 5-10% return of an aging bull market to other investors. I think they are words to live by. Oh, and in the meantime, don’t forget to man the lifeboats.
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