Update (3/13/2020):
Well, it is a Bear Market as of this week! We dipped well below the -20% line on March 12 due to the awful 10% meltdown that day. But we also recovered very nicely on Friday the 13th, of all days!!! I’m putting together some notes about my thoughts. To be published on Wednesday, March 18. Stay tuned! Good luck everybody! Stay invested! 🙂
Original Post (3/4/2020)
Volatility is back! Did it feel a little bit like a bear market last week? Actually, that wasn’t even a bear market, only a correction so far. Hence the title picture with the Koala “Bear,” which is not a bear at all but a marsupial. But it still felt like a mini-bear-market, didn’t it?
So, I thought it’s a good time to write a response to some of the questions I’ve been getting over the last few days:
- How bad is this event compared to other corrections? How long will this last?
- Should I sell my stocks now?
- Is this a good buying opportunity?
- How did some of the “exotic” investment styles fare during this volatile time (Yield Shield, Merriman’s Small-Cap Value)?
- What does this all mean for my retirement plans?
- Did your leveraged option writing strategy blow up already?
So many questions! Let’s shed some light on them…
How bad is this compared to other corrections? How long will this last?
If you recall my post from early 2019 Will FIRE turn into “Fake Independence Rapidly Evaporating?”, I included a table with some stock market stats, including the largest equity drawdown by calendar year. The median drawdown peak to trough in the typical calendar year is just about 10%, so you’d expect a drawdown of 10% or more about every second year. The 12.7% drop in the S&P 500 (Feb 19 to Feb 28) is nothing out of the ordinary! After a relatively low-volatility year with a 30+% return in 2019, one should have almost expected the pullback! So far, nothing to worry about, nothing out of the ordinary
How long will this last and will this get worse? Maybe the worst is already over? I was certainly encouraged by the big move on Monday. Only to see the market drop again by almost 3% on Tuesday. That volatility shouldn’t be a surprise, though. Nobody would seriously expect the uncertainty to just go away after a few days.
If history is any guide then even in this best possible case, where the Covid-19 causes only minor disruptions, I’d still prepare myself for at least several weeks, maybe months of uncertainty and pain in the stock market. If we look at some of the corrections over the last few years, and again I’m talking about the recent corrections that did not coincide with any lasting negative impact on the market and the economy, they still normally needed some time to blow over. For example:
- The August 2011 U.S. bond downgrade
- The August 2015 China devaluation
- The January 2016 Fed scare
- The February 2018 vol spike
- The Q4 2018 mini-meltdown
What they all have in common is that it took a while to reach the trough and a new high! I don’t expect the Covid-19 impact to just disappear after only two weeks either like nothing ever happened!
What if this virus turns into something more sinister? Again, I don’t believe that this is likely, see Dr. Grahama’s excellent post on FiPhysician.com. He’s an infectious disease doctor and makes a pretty convincing case that this virus will likely not be as dangerous as the media want to make it!
But I’ve seen some ominous signs. At both Costco and Walmart, they ran out of toilet paper. Why would they run out of toilet paper in the Pacific Northwest with so much timber and so many paper mills around here? Disinfecting wipes, rubbing alcohol were also sold out. Even more ominous, Walmart and Costco were already running low on or sold out of other essentials like bottled water, rice, canned beans, flour, etc. I hope it’s not a harbinger of something worse but just people who must have watched the “Doomsday Prepper” marathon on the Discovery Channel!
So, in the worst possible case, where a global pandemic indeed causes a global recession this would be just the beginning. A few months ago, I looked at the anatomy of past bear markets and found that from peak to trough it takes more than a year, on average. Which doesn’t sound so bad, but keep in mind that reaching a new (nominal) all-time-high took 4 years and 8 months on average and catching up with the old all-time-high plus inflation took almost 7 years. For some of the really bad events, you can also add another 50% or more to those time frames. Pretty scary, if you ask me!
But again, my working assumption, at least for now, is that the economy will muddle through because the virus concerns will eventually subside. Keep your fingers crossed!
Should I sell my stocks now?
The S&P 500 dropped below its 200-day moving average (and probably most other indexes as well) last week, so if you follow a momentum market timing approach this would have been a sell signal. If you strongly believe that Covid-19 will turn into a full-blown global recession, then sure, this might be a good time to still get out. If you believe that the market will drop 20% or even 50+% peak to bottom, then getting out at -10% and getting back in at -50% would be a huge market timing alpha!
Personally, I think that would be a mistake. What if you had sold at the bottom on Friday only to see the market recover 5% on Monday? Do you get back in? Hey, you were above the 200-day line again! Then sell again after the dip on Tuesday? A lot of investors get “whipsawed” by chasing such short-term moves. For most investors, staying the course is the best way.
If you have thoughts of selling all your equities now, maybe you don’t even want to look at the market for a while! Get off the computer and go on a hike! Total coincidence, I did go on a hike on Thursday last week when the market tanked by 4%. I went to Mt. St. Helens (90 minutes from our home in Camas) and I had no idea at all how bad the drop was because there’s no phone or data coverage anywhere along the trail! I’m glad I didn’t because I might have overreacted…
Watching the Mt. St. Helens Crater beats watching the S&P 500 crater!
More info on this hike:
Is this a good buying opportunity?
I’d always ask back: when would be a bad time to buy stocks? For me personally, while I accumulated assets between 2000 and 2018, I thought it was always a good buying opportunity! Either the market was going from one all-time-high to another, then why do I want to go against the momentum? Let the profits run and put more money into the market. Or the market was beaten down, then momentum may look bad but valuation looks awesome! Let’s buy stocks when they are on sale! Dollar-Cost-Averaging rules!
If you think that the virus will just be a blip in the current bull market just like all the other events over the last 11 years then this may indeed be a good buying opportunity if you have loose cash lying around. But heed the warning from above: Despite the bounce on Monday, the market might still get worse before it gets better. It happened in all of the other corrections before! The way down and the way up are rarely a straight linear path!
How did some of the “exotic” investment styles fare during this volatile time?
For the (mostly) passive investors and the broad index fund fans like myself and others in the FIRE community, there’s always the nagging doubt: is there a better way to invest and is a way to avoid some of the market pain? The internet is full of investing advice, some good and some not so good:
- The “Yield Shield” i.e., shift your boring old 60/40 portfolio to other ETFs with higher dividend and interest yield to help with “Sequence Risk” in retirement. I thoroughly debunked that approach in my Safe Withdrawal Rate Series, Part 29 (and follow-ups Part 30 and Part 31).
- “Small-Cap and Value stocks” as proposed by Paul Merriman and others. You invest in “Value” stocks and Small-Cap stocks. Hey, who doesn’t like value, right? Value is good! Unfortunately, the record of value and small-cap-value has been underwhelming recently as I pointed out in a post last year.
So, did the alternative portfolios with the “sexy” names perform better in 2020? Not at all. A simple, plain 60/40 portfolio (i.e., 60% S&P 500, 40% intermediate government bonds) would have been down by 2.5% up to February 28, 2020. The Yield “Shield” would have been down 5.4% and the Merriman moderate portfolio (60% stocks, 40% bonds) 6.4%.
And just to demonstrate that this isn’t cherry-picking just one short two-month time window, here’s the return comparison of a plain 60/40 vs. the “sexy” portfolios since 2014 (some of the Merriman ETFs were not available before then, but check out my historical backtests of the failed Yield “Shield” going back to 2007 in the SWR Series Part 29, Part 30, Part 31). The Yield “Shield” and Merriman Portfolio mostly underperformed the 60/40 portfolio. They each had only one calendar year where they posted a mild outperformance. But over the entire 74 months, the Yield “Shield” and Merriman portfolio lagged by 2.4% and 4.3%, respectively! (Returns via Portfolio Visualizer, see this link)
How’s that possible? Let’s look at what’s in those portfolios, i.e., the underlying ETFs. The equity portion of these alternative portfolios didn’t do particularly well in 2020. Sure, REITs outperformed the S&P 500 a bit. Even the total market index did slightly better than the S&P. But after that, it starts looking really grim: dividend stocks (VYM) underperformed by 4%. And most of the lineup in the Merriman portfolio, small-caps and value stocks of different flavors were an unmitigated disaster so far in 2020. Not a pretty picture!
Moving on to the Fixed Income portion. In market stress periods, the plain old boring intermediate bond (e.g., iShares IEF with 7-10-year Treasury bonds) is king. The Merriman ETFs certainly didn’t lose money but they underperformed the IEF due to a shorter duration. And in the Yield “Shield” portfolio, shifting into corporate bonds and Preferreds has the expected outcome: corporate bonds don’t do as well government bonds (more macro risk, less “safe haven” assets) and Preferred Shares get clobbered because of their significant macro and equity exposure, as they always do! The Fixed Income portion of the Yield “Shield” and especially the Preferred Shares will always be a complete train wreck in market stress periods!
So, long story short, simplicity is king. Don’t fall for the bling, don’t fall for the B.S. – it’s best to stick to the simple passive index portfolio.
What does this all mean for my retirement plans?
Most folks in the FIRE community are still years away from retirement. Keep investing, and do your dollar-cost averaging.
For current retirees or folks close to retirement, it certainly sounds a bit scarier. Sequence of Return Risk is the #1 retirement killer. But most investors who did their homework right should be OK. If you started with a modest initial withdrawal rate then even with the small decline since the peak you should still be safe. Of course, if you listened to some of the FIRE cowboys out there (“who cares about the withdrawal rate, just do 5% or 6% or 7%, as long as you’re flexible”) then indeed you might have to be flexible and cut your spending after only a few months in retirement. But I can’t imagine many readers of the ERN blog fall into that category. Right?
Did my leveraged option writing strategy blow up already?
Hah, glad you asked! I get questions like that all the time when there’s a spike in volatility and the market drops. My put writing strategy definitely got dinged this year, especially on February 24 during the first large move downhill. And I even had some small losses already in January. But so far, knock on wood, it worked out pretty well compared to the S&P 500 index: As of March 3, with the overall portfolio (short puts on margin + margin cash in bond funds), I was up by 0.4% for the year. Though the option writing portion alone is still down! Still pretty good, though, considering that the S&P 500 is down quite a bit.
But why don’t you lose your shirt when the market is dropping so precipitously? Especially with 2.5x leverage? The beauty of the put-writing strategy is that, if done right(!), you can make money even if the market keeps dropping after the initial fall. Exactly as it happened last week. I certainly lost some money on Monday, but I was able to sell puts with strikes far below the current index level (sometimes 10-15% below the current value and 2 days to expiration) thanks to the extreme increase in implied volatility. The market still got close to breaking through my strikes on Wednesday and Friday last week, so you need some nerves and the right stomach to do this consistently!
So, the February meltdown was scary but still quite a bit less worrisome than some of the other stress periods I’ve been through (e.g., August 2015 or February 2018). But thanks for asking how I’m doing, everybody! You are all a bunch of rubbernecks! 🙂
Hope you enjoyed today’s post! Looking forward to your comments and suggestions!
Title picture credit: Lee von Gynz-Guethle