December 2020 Stock & Bond Market Summary

The stock market is precarious now. It’s wise to consider a move or two.

Here we Are

We financial advisors try our best to persuade clients to take a long-term approach to their investments. Unless stock-trading is a business to you—or a sport—you don’t need to keep close tabs on the daily ups and downs of the market. That rule, like every rule has an occasional exception. There are times when the warning lights are flashing red, and for a short time we need to take whatever action might be available to gain a little protection.

As you might guess, I believe these next few months are one of those times. The overall market is overvalued right now. Any big move will go to the downside. Any investor should make a habit of gaining wider perspective. I don’t believe watching CNBC helps with that very much, designed as it is to hold attention for as long as possible . Dig deeper, every once in a while. Here are two market perspective tools that I think are underused…

Shiller P/E Ratio

https://www.multpl.com/shiller-pe

Buffet Indicator

https://www.gurufocus.com/stock-market-valuations.php

Those two resources briefly explain their methods and speak for themselves. I recommend you bookmark both. Here’s my market commentary in bullet-point form first:

  • Interest rates are near zero….
  • … businesses (and therefore stock prices) like low interest rates
  • The Fed is printing money—as it should—in the form of stimulus checks
  • Younger people who don’t have (and don’t need) short-term market perspective are flooding in with new investment tools like Robin Hood

Low interest rates mean high prices for bonds. If you hold a bond for income you don’t care. But if you need to buy a new bond, conditions aren’t at all attractive.

An alternative to a significant market break is a sideways market for many quarters until economic fundamentals support stock valuations. I find that unlikely. The stock market likes to go up. During the bear market part of the market cycle, it likes to go down. In general, it doesn’t like to stay the same month after month, year after year. If you believe a market break is coming, there are ways to hedge stock losses in your portfolio.

Hedging Tactics

Reduce Equities

This is probably the only option available in your 401(k) account. Money market mutual funds and ETFs don’t care (much) about stock prices. You can park as much of your account value as you feel comfortable with into whatever your money market choice is. You can accomplish pretty much the same thing by transferring that value to one or more of your bond choices. Usually, there would be a bit more gain (and risk) in your bond mutual fund or ETF when compared to money market. These days with rates near zero, that option isn’t too much different than money market.

Buy Volatility

When that market correction arrives, it’ll be accompanied by rising volatility. Since 1993, the Chicago Board of Exchange has kept an index that tracks expectations of future volatility, called CBOE Volatility Index- ^VIX. As stocks decrease in value through a systemic downturn, a position in VIX would rise, partially offsetting the losses. There are also ways to offset 2X or 3X the level of VIX. I personally don’t love those leveraged versions, but there’s a place for everything somewhere out there, I guess.

It’s unlikely a VIX ETF is available in your 401(k) options. If this possibility appeals, you’ll need to set the hedge in some other account, coordinated properly with all your investment accounts

Short the Market

This option is almost certainly not available in your 401(k). There are two main ways to take a short position—one that makes you money when a price goes down. You can sell a stock or index short, borrowing the securities and paying interest on the loan. This requires a margin option in your brokerage account. The second choice is to buy put option contracts that obligate another party to buy securities later on a price you agree upon now. Generally, you won’t worry about exercising in that way—you’ll just sell the option itself when it becomes more valuable. With a market break, the value of that option changes more rapidly than the underlying security. There are more details to know about options, beyond the scope of this overview article. Now would be a good time to learn more.

For most, buying the put contract is simpler than selling short. You’ll have to have options trading available in your brokerage account. If it is, buying and selling options is not much more complicated than trading stocks.

The End Result

This is a moment to take modest action if you’re in or close to retirement (or as I like to call it, your Collect Phase). Some people believe the only protection is to take their portfolio to cash. It’s valuable to be aware of other choices that you can follow up and learn more about. It’s not possible to time the market in the short-term, so one should only reluctantly move completely to the sidelines. It’s possible to lose out on some gains. You could be sitting out without a clear signal to get back in for a long time. Only for those that like to be active in managing their investments… you may want to cash out temporarily when the decline is well under way, looking to get back in as soon as the downward momentum has lessened. For most, don’t go to cash…hedge.

This is a great conversation to start with your professional financial advisor.

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