Wednesday’s trading saw stocks, treasuries, corporate bonds, gold, and oil all get hammered. The only game in town right now is to ride with the bears, not the bulls.
No matter how much something has gone down or how quickly it is going down, there has to be someone that holds long positions in it. Stocks must be held by someone, even if the price goes to zero. Someone has to hold bonds all the way to maturity. Somebody has to hold precious metals like gold. As long as we’re still producing commodities, there will be those who will be in the market to buy them when the contracts that they place to do so become exercised. It just does not have to be us.
It is fair to say that financial assets are hurting right now. We usually will see people migrate from assets that are going down, like stocks, toward better performing assets, like bonds or gold. People set up positions in these other assets in advance, to buffer losses in their stock positions when they occur, and we’ve sure seen plenty of that lately. Once a big pullback in stocks is underway, people will move away from stocks even more, into these other assets, often without much thought.
We call this hedging your stock positions, and while it’s a clear bad move to hedge stocks when they are doing well, unless you have to, there are times when this is really needed, like right now. In order to have any real sense of what we are doing, we need to distinguish ourselves as individual investors from the large investors, and realize that we do not have the liquidity issues that big investors do, and not just turn our backs on opportunities to help ourselves by looking to behave like institutions and funds do.
We will always see a strong bias to the long side out there due to the necessity of these big investors to take on more risk on the long side than we do. Most funds aren’t allowed to trade on the short side, meaning holding positions that make money when the price of an asset goes down, and most funds can’t even flee to cash. Their filing with regulators requires them to be close to fully invested in whatever they invest in, and they are left to stand their ground and take on the most ferocious bears they may encounter and suffer whatever damage they may choose to inflict.
People also take this pledge, completely voluntarily, those who adopt what we call the buy and hold philosophy. They feel trapped like a lot of funds do in bear markets, and don’t even switch assets in dire times like this. The investment industry is there to keep encouraging them to hold on, and we may also see funds add to their positions during bad times like this, in spite of whether it may be a good time at all to do it.
There are a few reasons why they do this, none of them good, and this starts with the idea that stocks always come back sooner or later. This twisted model makes several bad assumptions, with one of them being that this is a choice to cut your losses and presumably stop investing and holding on to continue to pursue your long-term investment goals, as if these were the only options.
During bull markets, investing is all too easy, as bull markets mean that asset prices are increasing, and it’s not that hard to ride these moves if just about everything keeps going up. You might make some bad choices such as investing in a sector like oil that has been pounded even during the best of times lately, assets that declined significantly over the last 5 years in spite of a strong bull market in stocks otherwise, but it’s not hard to get market returns because all you need is to invest in stock index funds.
We may even take this growth situation for granted, and many do, hearing the music play over the last 11 years for instance. When the music stops, and then turns to a lot of banging and crashing instead, eerie sounds of metal on metal like a train makes when they slam on the brakes, the game is really on.
This is where we see the old adage play out that says a fool and his money are soon parted. Investment strategies that have worked just fine for quite a while because they suit the market suddenly turn into the worst thing you can do.
Investing on the long side in bull markets trades with the overall trend, which is definitely what we always need to be doing. All bull markets have their ebbs and flows, and we always see them from time to time, although if the ebb isn’t significant enough to reverse the longer-term trend from bullish to bearish, hanging on remains a good idea.
There are those who look to time these smaller ebbs, and you can certainly help yourself with this if you are skilled enough, but investors generally don’t have any skills here and can easily do more harm than good by trying this. This skill can be learned, and it’s not hard at all to come up with some strategies that at least have us stepping out during these lulls, but do require a real commitment which very few investors are willing to make.
When the larger trends do shift though, this is the point where investors no longer have the luxury of relying on complete passivity. At this point, the house has caught fire, and if we insist on staying in our houses in times of crisis, at the very least, we’re going to be breathing in a whole lot of smoke and damage our lungs.
We can’t just hold out and assume that this will be some sort of effective response, thinking that things will eventually rebound and have us back on course, versus looking to protect ourselves and missing out on not only the risk that is going on now but future profits as well. While this should appear rather foolish to us, there are plenty of investors that think this way and will boast about such things as holding on during the 2007-09 bear market and be well up from those levels today.
Comparing Alternatives Requires That We Actually Compare
Whenever we compare actions, we need to actually compare both to see what is or would have been the best thing to do. When we do this, we need to compare all reasonable actions, and this is the only way we’ll even know what the best approach is or would have been.
The obvious response to those who brag about seeing the value of their stocks decline by more than half but being happy that they are up from where things started to unravel is that we could both be out when things turn to crap and get back in when we start to recover.
Those who did use their heads more by not limiting their approach to just one avoided much of the carnage during this period, and were able to re-enter their stock positions after the dust settled and we got into recovery mode. The way to measure the success of such a plan is to compare the exit and re-entry points, and anytime you got out and then got back in lower, you made a profit over buy and hold, and in this case, a big one.
If someone had a stock portfolio worth $100,000 when the financial crisis back then hit home, when we all knew things were about to get scary, saw it drop to $50,000 once things turned around, and hung on for the big move back would have been sitting with $250,000 last month, and may want to give themselves a big pat on the back for being so disciplined.
As it turns out, this strategy worked very well other than when the bears come to play, back during that crisis, and once again during the current one. We do not want to invest over our heads, and managing the relatively small and transitory wiggles in stock prices that we see during any bull market should not really interest us much, since the threat is low with these moves against us and it takes a lot more skill to manage this properly than just waiting for the air raid sirens and reacting with sticking to the big events does.
Sometimes though, the threats can be pretty large indeed, when we deal with real bears and not just their little cubs. If we got out when the crisis hit back then, and got back in when it was over, this cashes out to more than just saving this $50,000 back then, just saving 50% of this 60% downward move. This is not just about that, having $300,000 last month instead of the $250,000 that buy and hold investors are so proud of, as the difference at any time isn’t just $50,000, it’s 50%.
Going back to the obvious re-entry point in 2009, our $100,000 that we have preserved by protecting it from this obvious bear has us owning twice as much stock as the buy and hold folks, not only back then but at any point in time in the future. This actually has us sitting with $500,000 to their only $250,000, and if one day they work their way up to a million, we’ll have two million, because we own twice as much stock.
This is the most important thing that these smug investors miss, alongside virtually everyone else in the investment world. It might be hard to imagine how so many people make such an elementary mistake, as this only requires grade school math and a willingness to actually compare alternatives. It’s the last part that hardly anyone is willing to do.
Instead, what we do is try our best to pretend that our path is the only true one, like we see with religious followers, although without feeling the need to look beyond our path, we’re doomed to it.
This has all happened again of course, with stocks down about 30% in the last month and a half. For those who stuck to their buy and hold plan, this means that their $250,000 has dropped to $175,000, while those who run from real bears have only lost 5%, the point where all the alarms were ringing to have us exit a building that had caught fire with the fire set to burn pretty hot, as it did.
Those who are just the sort that just likes to be on the sidelines during big downturns, and not even the type that wishes to take advantage of these opportunities, they would be left with $475,000, which is a lot more than $175,000. The buy and hold folks may see a nominal recovery down the road, getting at least most of their losses back we may presume, but will fall even further behind as we get back in at lower prices and own even more stock than they do.
Let’s say we peak at this 30% when these fears of a pandemic finally end, when it is now safe to be in stocks, and their paying attention to managing their risk has caused them to save themselves from 20% of this move, the 30% less the 5% that they held on while waiting for the other shoe to drop and the 5% they had to watch while they are waiting to get back in.
This leaves them with a net advantage of 20%, and this is not just a nominal advantage of 20% over those who held on, this 20% plays from now on. We own 20% more stock than the deer in headlights set, and no matter how much the market goes up over time, our returns will be 20% higher than theirs, year after year. This is a big deal indeed.
We Think Diluting Our Assets Helps Protect Us, But Only if We Don’t Check
That’s not all though. These buy and hold investors, due to their handcuffing themselves to their stocks and throwing away the key, will still want to do something to protect themselves from bears, so they continually maintain diluted stock positions, for instance with half of their money in bonds and half in stocks. This is called a balanced approach, but the real balancing that needs to happen is to have our minds opened more appropriately, rather than their refusing to compare alternatives in the same manner that they cling to their buy and hold strategy without thinking about it.
There is a long-term differential between stocks and bonds, and if we insist on going half and half during bull markets, this will put our returns down by quite a bit. If stocks have gone up by 400% over a time, as they have with this recent bull market, and bonds only go up by 40%, we have a 360% gap that we have to account for.
In our example, our buy and hold investor only saw their portfolio drop to $75,000 during the crash, but during the recovery, this did not go up to $250,000, it only rose to $165,000, because half of their money got this crappy return instead of the full measure of stock gains.
Only half of their portfolio suffered this recent 30% decline, but this takes us down to $140,000, as opposed to the $175,000 that we would have if we put all of our money in stocks instead. This didn’t exactly protect our portfolio value from declining more, when we are left so less well off as a result of this pretend hedge.
Due to this much panic running in the streets and the severe economic price that we’ve come to be willing to pay to try to slow down the spread of COVID-19, the particular bear that is at the wheel is a dangerous one indeed. We got to really see this bear’s power in swatting down asset prices on Wednesday, when everything got swatted big, including stocks, treasuries, corporate bonds, gold, and oil.
All of these, besides oil, are assets that investors like to use to hedge, whether they just hold a certain portion in them rain or shine, or flee to them when the big rains come. West Texas Intermediate had traded over $30 a barrel on Tuesday, but on Wednesday, it kissed the $20 mark. This bear has some pretty powerful paws indeed.
If you trade commodities, only traders that died at their computers or those with a death wish remained long through this move, and since there is really no up or down with commodities trading, it’s just a matter of which side you want to be on. There were huge amounts of money to be made for futures traders during this time, where the price dropped by $7 in a way that was so straight down that 15 minute bars would have kept you in this the whole time, and got you out near the bottom on Wednesday afternoon.
There was an easy 20% return here in a single day, and if you think that this is impressive, try multiplying this by the leverage these traders use, up to 14 times. That’s up to 280% in a single day, not just the relatively pedestrian 20%.
The fun wasn’t over yet though, as we then had a nice bounce off $20 to $24, and once again, 15-minute bars were plenty to capture most of this move. Oil may have been hammered, but this is a trader’s dream.
This is included to try to serve as a wake-up call to those investors who just think that we only all make money when things go up and lose when things go down. We choose which side to bet on, whether we consciously do so or not.
At a minimum, we need to know when to throw in our hand and wait for a better one, but sharper investors, or at least those who are open to the idea, can make even more money during bear markets than during bull markets. This does take a little skill, but nowhere near as much as we may think.
We could even throw out a single simple idea that can serve to guide investors who wish to play when the bears are out, which is simply wanting to go with the animal that happens to be in control now. We are not talking about little jiggles in the overall chart of something on the way to higher prices, we’re talking real events that are of no small magnitude like this one.
When it’s the bears’ turn, this greatly increases the risk of stubbornly insisting on keeping our money on the bull side of the table, in addition to all the losses that this involves. Risk is important to look at because that’s actually our guide, although there are plenty of people who only open their eyes a bit after they have been slaughtered, which is a stupid way to manage risk of course.
This is like riding the subway every day to work without worrying too much about getting robbed, and doing the exact same thing when the subway has been overrun by gangsters and the chance of your getting rolled goes from low to extremely high. You need to pay attention to how risk changes and take appropriate action when it does, like finding another way to work when things get so dangerous.
We called going short treasuries a little while ago, and they have been going up ever since. The iShares UltraPro Short 20+ Year Treasury is up over 20% since we recommended it, in only 6 trading days. It was clear enough that the treasury market had bottomed then, and we’ve already moved quite a bit off of it, with more likely to come.
Those who insisted on staying long bonds after they wore out their welcome have lost money over this time, and no matter how much you may be up in a position, it’s just better to make money than lose it.
Corporate bonds have been even more bearish, as the worry of defaults continues to rise as we tie up our economy more and more. The Fed is there to help, the most extreme measure they can take, but this will only serve as a stop gap measure and keep them from going too low. Meanwhile, the default risk is still there, as the price that the bonds a company has issued doesn’t affect them at all, and this move was purely to help investors, not businesses.
We need to instead be focusing on keeping these businesses from going under, setting this money in reserve and using it to make interest payments for the companies when they can no longer do so and would otherwise default on their debt. Our bedroom is burning, and the Fed not only aimed their hoses at a different part of the house, they are watering down the wrong house as well.
Gold is also underperforming, and the choice of assets isn’t to places normally considered to be safe, if safe means protecting against long side risk, the fear now is so great that nothing is considered to be safe presently. It’s plenty safe on the sidelines, and plenty safe enough to look to swim with this powerful tide instead of against it if we are up for it.