Notes: I’m sharing a letter that we sent out on Saturday April 7, 2017 to our clients, prospects and friends to let them know how we’re handling this market correction.
Sandwiched between two “down” days in the markets this week (Monday and Friday), were three “up” days, culminating in an overall 1.4% weekly loss in the S&P 500 index. Fears of a full-blown trade war receded on Tuesday, resulting in a mid-week rally that eventually faded on Friday, as trade war fears resurfaced and weighed on the markets.
Despite the threats of a trade war, the outlook for the economy and corporate earnings, the fundamentals that truly drive the markets over the long term, both remain quite positive. Both surveys from the Institute for Supply Management (manufacturing and services) are firmly anchored in growth territory. And although yesterday’s monthly payroll report revealed that there were fewer jobs created in March (probably weather related), the unemployment rate remained unchanged at 4.1%.
The broad market indexes are fluctuating near their recent lows as the market correction (and volatility) continues to unfold. The typical market correction lasts roughly 12 to 16 weeks, and this one is about 11 weeks old. But there are signs that the market is in a final bottoming process that could potentially yield a multi-week or multi-month rally which could start any day now. Corrections never feel good while they’re happening, but they’re a healthy way of “digesting” past gains and to keep the markets from overheating after a prolonged period of going up. January was particularly strong this year, but all those gains and more have been surrendered during this correction.
During this correction, clients may have noticed increased trading activities in their accounts. Our standard practice at the start of and during a correction are to:
- Raise cash levels by selling some profitable or underperforming positions.
- Increase hedges (a hedge is risk reducing instrument) through the use of inverse funds (funds that go up when the market goes down) and options.
- Adjust (short) options that were sold to take advantage of higher premiums and volatility, which results in additional portfolio income as we roll out to later months. Short options also act as hedges on the portfolio.
- Use technical signals in the market to identify potential bottoms, to begin putting available cash to work in new (now lower cost) positions.
- When uncertainty and risk are high, but opportunities present themselves, we may decide to limit client risk through the purchase of call options, or by selling put options, instead of purchasing outright shares. Both approaches increase exposure to the market with less risk than outright share purchases.
- Identify spots where it is deemed prudent to remove or trim hedges to reduce their overall “drag” on the portfolio. Hedges that are removed may be re-instated if the markets unexpectedly turn back down, sometimes even a day or two later.
- Monitor new positions purchased during the early stages of market recovery to ensure that these positions are “working”, keeping them on a short leash. All such positions are considered short-term until the market ultimately proves itself. Some positions that turn profitable but return to their buy point are sold for a small profit or small loss.
As the market showed signs of making a bottom early in the week, we were particularly active in reducing hedges and testing new positions. Because of Friday’s decline, unfortunately, we found ourselves reinstating some of those hedges and selling some of the newly established positions for a small profit.
Back to square one.
The process of market bottoming is an inexact science, much like the process of investing, so fits and starts are to be expected. As Friday’s decline gave back all the week’s gains and then some, we begin the process of looking for another market bottom next week.
During a correction (or outright bear market) our objectives remain to protect client capital first, and grow it second. Until safer market conditions present themselves, and volatility subsides, we will remain defensive and have a bit of an “itchy trigger finger” with new and existing positions. We trust and hope that you agree with this approach, even if it increases the number of trades we make. Please excuse the extra trade confirmations that hit your in-box.
Next week kicks off the start of quarterly corporate earnings reporting season, wherein companies report their financial results for the first quarter of 2018. Estimates are that companies expect to report earnings that are on average 17% higher than the first quarter of 2017. If those results pan out as expected or better, we may be looking at this correction in the rear view mirror in a few weeks.
The dichotomy between a solid economy and a nervous, volatile market is a dilemma that requires patient discipline and an understanding of market history. It is still too early to determine if this is just a lengthy correction or if it could lead to a further decline and a full-blown bear market. Given the elevated risk and persistent volatility, however, it’s important to remain defensively positioned and to objectively evaluate key indicators as the evidence continues to unfold.
If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.
Source: InvesTech Research
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