This week we’ll go into the inbox to answer two popular questions I’ve been asked lately. The markets have been difficult (understatement of the month) so naturally many people are looking for some guidance. Several new readers, and a couple long time ones, have asked how to handle portfolios during volatile markets like this, and if I’ve made any changes to our market outlook.
The answer to the first question is simple: we stick to our strategy, and readers should stick to theirs. While some investors have one strategy for the good times, and another for the bad, I’ve always found it difficult to figure out when to do the switching. To do that successfully and repeatedly, you need an ability to tell the future, which I lined up for but never got. Instead, I’ve found it far simpler to use a strategy that anticipates there will be tough times now and then, and doesn’t require market predictions to succeed. Generally, investors should look for a strategy that can run more-or-less on autopilot through different conditions, can generate a decent long term return, and is priced fairly for the long term performance and advice received.
The answer to the second question, have I changed my outlook, is a little more detailed. In the long term, no big change. I’ve written in past about how I determine long term expectations for benchmark returns, settling on gains of about three to four percent per year on average over the next ten years. With markets currently much lower than they were even six months ago, four to five percent over the long term seems reasonable from here. Over the long term, markets generally demonstrate mean reversion. Like a pendulum, the lower (higher) they go today, the higher (lower) we can expect them to go in the future.
In the shorter term, it’s anyone’s guess. However there are two things I’m looking at to help determine my level of confidence in the market. These things are not exhaustive, and they don’t in the slightest inform how, when, and why we invest in the companies or ETFs we choose. Instead these factors are best used as a general barometer of how things are going for the average investor.
First, I look at the yield curve. I’ve written in the past about what the yield curve tells us and how to interpret what its saying. Yield curve information is generally big picture, with longer lasting economic and market effects. Currently, Canadian shorter term interest rates (one year and less maturity) are at about the same level as medium term interest rates (five years maturity). Although this makes it a degree tougher for financial companies to do business, it’s not until short term rates are higher than long term rates (ten years and more) that things really start to get pinched. From this perspective, today’s Canadian lending and credit rates are not ideal, but remain far from dire. US interest rates, on the other hand, look entirely normal. For now I’ll give the yield curve a passing grade until it proves otherwise.
Second, I look at volatility futures. I’ve also written in the past some notes about how to interpret volatility information. In contrast to the yield curve, volatility futures are usually small picture, with shorter term effects on the market. The thinking goes that under normal conditions it costs more to buy long term portfolio insurance than to buy short term portfolio insurance. That’s perfectly normal because investors have a clearer picture of short term risks, and a hazier picture of long term risks. However over the last couple weeks we’re seeing the opposite happen: short term portfolio insurance now costs more (much more) than long term insurance. This means investors view the short term as hazier, and the long term as clearer. As long as this remains the case, investors should expect higher volatility than average. Historically, it’s not until we see this relationship go back to normal that we usually see a lasting market rally take shape. For that reason, I’ll give the volatility futures a failing grade for now.
Again, while yield curves and volatility futures are helpful in putting together an understanding of the market, under no circumstances should they be used to time the market. Understanding something is a much different process than trying to consistently earn a profit from it. That said, the current situation looks reasonable to me. We know that in the short term things look bad, and could even get worse, while in the long term the outlook remains positive. That’s usually a recipe for investor success.
That’s likely a far less exciting answer than some readers were anticipating, but that’s something I can live with. Personally, I’ll tell you I am excited… very excited. That’s because eventually, when this clears, there’s another market rally to look forward to. When that happens, we’ll be running our Growth and Income strategies as always, and ready to participate in long term gains.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.