Is now the time to enact Plan B?
Published 4th August 2022
As per previous publications, while Global Central Banks have been pumping money into the economy through Quantitative Easing (QE), the levels of liquidity have risen sharply, enabling the market to deal with any adverse events. In addition to additional cash in the system, interest rates breached negative levels in many jurisdictions around the world, creating a new definition of low interest rates. Rounding out the trifecta are Governments who have pumped cash into our system during 2020 – 2021. This has completely distorted all asset classes, leading to extreme valuations across the board. Now that these Central Banks and Governments have removed the punch bowl, we are seeing the market fundamentals change; inflation, wage inflation and interest rates are running at elevated levels, while economic growth is beginning to slow – as evidenced by a technical recession in the USA.
The market type has changed, we have managed this through sporadic bouts of profit taking and increased allocation to Alternative assets. We also went conservative in our Defensive allocation however, Government bonds did increase in yield (largest move in 200 years globally) resulting in falling valuations. These were not to the same extent as equities; however, they didn’t protect the portfolio in any meaningful way. We understand why this happened and have rectified the plan going forward.
We have been waiting for the pullback to reach levels that are compelling for new investment; where the risk of further falls is offset by the valuations you are paying for the earnings. We are close to this level, but not quite there yet. As such, you have not been advised to buy equities on the most recent pullback of 15% to 20% in equities. While this could be seen as a miscalculation (if this is a pullback in a continuing bull market), protecting capital is our number one objective within the larger strategy of making money; we do not believe they are mutually exclusive.
There are numerous market pundits pontificating on interest rates and inflation, when will they stop rising, will they pull back and what damage will be done in the meantime. The market type has changed and until we have clarity (or a much larger pullback), we will not be adding to growth assets. We will continue to be fully invested while simultaneously increasing the ability for your portfolio to make money during volatility while protecting capital. We have been defensively positioned for several months and will add to this defense if it is required.
Important: the article below will outline what to expect from us over the next phase of this market.
Note: The strategy outlined below will not be appropriate for all portfolios or clients. It is best suited to a long-term investment strategy with a risk profile of 'Balanced' or higher. Please speak with your advisor for clarity on your personal situation.
Is now the time to enact Plan B?????
Summary
For the past 12 or so years we have been running with an investment strategy - we unimaginatively call this?Plan A.
Plan?A is used in a long-term rising market. It morphs over time allowing you to compound your returns. It begins on pessimism and builds in the face of adversity. You need courage to enact Plan A. It means you buy the dips when the fear is at its greatest. However, the risk is lower as the price you pay for these earnings is lower. This defines the difference between fear and risk.
Plan B, in part, borrows from Plan A. However, it is more flexible, ever-changing, and difficult to predict. There is more nuance and less predictability with Plan B, and the rewards are muted in comparison as we lock in the gains, not letting them run.
Plan B is used in a down/sideways market. It operates best during volatility, beginning on optimism and euphoria before turning into a roller-coaster. Once again, you need courage to enact Plan B. You buy in the dips when fear is at its greatest, only to sell on a bounce (remember the bounce is not guaranteed) to lock in incremental gains. It is a trading strategy that requires flexibility and sometimes forgiveness.
As you will have seen from the two charts above, they are very different in nature. Plan A is compounding returns, while Plan B has a larger trading component. At all times we remain exposed to the market through your bespoke asset allocation. We are not trying to pick 'tops' and 'bottoms'; we are trying to use the paradox of fear and greed to our advantage.
You will see in Plan B we would buy after the market had a significant pullback – potentially 25% - 30%+. Then we would lock in gains on a rebound (if that did eventuate). These gains may be anywhere between 10% - 20%. If over a 7-year down/sideways market, you were able to do this 2 or 3 times, that would be a great outcome. I am not hoping for a 7-year down/sideways market by the way!
At the end of Plan A, you are inadvertently looking to lock in profit as the market is getting expensive. At the end of Plan B, you are unintentionally adding to equities as the market is providing more value. In neither instance do you know if it is indeed the top or bottom, and this is never the objective. All you are doing is using market valuation and probabilities to your greatest advantage; to make a capital gain or protect against a capital loss.
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The Risks of Plan B
The risk with Plan B is that a fall of 25% may turn into a fall of 50%. If this were the case, you would be overweight equities as the market is falling, exacerbating any capital draw-down. We would hold the additional purchases and wait for a rebound or the start of the new rising market. We wouldn’t be panicking and selling the loss-making investments. The reason we wouldn’t sell the trades is because we are buying 25% lower, closer to fair value. From a long-term investment perspective, that is a positive; it will just hurt our ego (and your portfolio valuation) in the intervening time.
The Plan B chart illustrates how we propose to lock-in gains, only for the market to continue higher, thus leaving money on the table. This is a risk. However, we are not investing large sums of money (typically 3% - 5% of the portfolio) and the risk is mitigated. You are still invested as per your asset allocation - you will benefit in accordance with this.
Stock Selection in Plan B
From a stock selection perspective, there is a change between the two plans. We move from 'all-out growth' stocks, to a more selective exposure where cash flow, dividends, pricing power and sustainable earnings growth are paramount. In other words, we move from a market where the rising tide lifts all boats, to one where the receding tide catches out all those who have been swimming naked. We buy companies that we think will still be in operation irrespective of the economic realities. When the clouds recede, they will be well placed to prosper. You already have some of these in your portfolio.
Portfolio Construction in Plan B
From a portfolio construction perspective, we move to a position of relative defensiveness. We look to alternative assets like Long Short Funds, Hedge Funds and Absolute Return Funds to provide returns that are less correlated to a falling market. These funds have a history of making positive relative returns through this stage of the cycle. It is a way of keeping invested in the market for the long-term with your patient capital, while mitigating the probability of a capital draw down. It also allows us to stay invested in equities during the down/sideways market. History shows, if you miss out on the first few months of a new bull market, you will miss out on 20%+ returns.
We want to stay invested… in a moderately defensive manner.
Enacting Plan B
To enact Plan B is very simple if you leave your emotions at the door. You will be investing when fear is at its greatest and your reluctance to invest is at its highest. This is when you need to put on your long-term investing lens and see the potential value of investing when others are fearful.?
Note: As mentioned above this type of change and strategy does carry risk and you should discuss this with your advisor.
Definitions
All of the below invest in shares/companies on the share market, they just have different objectives around capital protection and expected return.
A fund you would find in your Equities Asset Allocation (Magellan, MFS, Coopers, Fairlight or Nanuk)
The above are 'long only' funds. A 'long only' fund holds investments that increase in value when the market rises and decreases in value when the market falls. They are designed to outperform the index. As such, you should expect them to track it by 2% - 4% up and down over time.
A fund you would find in your Alternative Asset Allocation (Ausbil Long/Short or Munro Global)
A 'long-short' fund holds investments long, while also selling securities it does not own (short). The goal of a long-short fund is to find investments anticipated to go up, as well as investments anticipated to go down. Investing in both aims to increase returns.
An 'Absolute Return Fund' holds investments, both long and short in order to produce a gain, or avoid a loss, regardless of the overall market conditions.
Alternative assets can invest using options, derivatives, currency, futures contract, commodities etc.
Relative Returns
Relative returns are the return of an investment compared to a benchmark.
For example, if the index fell 15% and your fund fell 5%, this would be a positive relative return of 10%.