investing in bull and bear markets: what’s the difference?

Presentation to AAIIPresentation to AAII

Baton Rouge Chapter Baton Rouge Chapter MeetingMeeting

September 10, 2011September 10, 2011

Investing in Bull and Investing in Bull and Bear Markets: What’s Bear Markets: What’s

the Difference?the Difference?

2Don Lansing ([email protected])


Mutual FundsMutual Funds Mutual Funds originally offered pre-Mutual Funds originally offered pre-

packaged diversificationpackaged diversification Modern Portfolio Theory where risk is managed Modern Portfolio Theory where risk is managed

through diversificationthrough diversification John Bogle (Vanguard) championed passive John Bogle (Vanguard) championed passive

investing noting that it was almost investing noting that it was almost impossible to consistently choose impossible to consistently choose outperforming managersoutperforming managers Focus was on driving costs lower – the one Focus was on driving costs lower – the one

variable in the passive equationvariable in the passive equation Fidelity launched sector funds to further the Fidelity launched sector funds to further the

passive investing landscapepassive investing landscape


Exchange-traded Funds Exchange-traded Funds (ETF)(ETF)

ETFs are like funds in structure (baskets ETFs are like funds in structure (baskets of securities) but trade like stocks (trade of securities) but trade like stocks (trade throughout the day based on prevailing throughout the day based on prevailing market price).market price).

ETFs offer some advantages over mutual ETFs offer some advantages over mutual funds:funds: Cheaper in cost (typically 0.5% versus Cheaper in cost (typically 0.5% versus

1.5%)1.5%) Give investor control over tax effectsGive investor control over tax effects Give investor control over timing of tradeGive investor control over timing of trade


Exchange-traded Funds Exchange-traded Funds (ETF)(ETF)

ETFs initially offered an alternative to ETFs initially offered an alternative to passive index investing (e.g. SPY). In the passive index investing (e.g. SPY). In the past decade, they went beyond:past decade, they went beyond:

Easy access to previously inaccessible Easy access to previously inaccessible marketsmarkets Individual countries – e.g. Brazil, Thailand, IsraelIndividual countries – e.g. Brazil, Thailand, Israel Individual commodities – e.g. Sugar, Cotton, Individual commodities – e.g. Sugar, Cotton,

Crude oilCrude oil

Built-in leverageBuilt-in leverage Allows leverage in IRA accountsAllows leverage in IRA accounts Use less money for hedgingUse less money for hedging Accelerate returns (and losses)Accelerate returns (and losses)


ETF ConsiderationsETF Considerations

Consider liquidity when investingConsider liquidity when investing More volume = better pricingMore volume = better pricing Less volume > use limit ordersLess volume > use limit orders

Exchange-traded Notes (ETN)Exchange-traded Notes (ETN) Sort of a bond backed by issuing firmSort of a bond backed by issuing firm Notes typically have 10-20 year+ termNotes typically have 10-20 year+ term Simpler tax treatment than ETFs Simpler tax treatment than ETFs Dependent on ability of firm to pay off Dependent on ability of firm to pay off

notenote

7

Discussion of RiskDiscussion of Risk

What is risk?What is risk? Often viewed as standard Often viewed as standard deviation of return – up and down swings deviation of return – up and down swings in returnin return Deviation is typically viewed as change from Deviation is typically viewed as change from

account peak – what we call “drawdown”account peak – what we call “drawdown” Investors emotionally “own” an asset valueInvestors emotionally “own” an asset value

Deviation is dangerous because it pushes Deviation is dangerous because it pushes emotional buttons in individual investors emotional buttons in individual investors makes them anxious, induces fear, …makes them anxious, induces fear, …

Thus, the goal is to minimize drawdown and Thus, the goal is to minimize drawdown and hold on to the vast bulk of gainshold on to the vast bulk of gains


Discussion of ReturnDiscussion of Return

Stock investors refer to S&P 500 as Stock investors refer to S&P 500 as the expected return the expected return Rarely adjust that number for riskRarely adjust that number for risk

Bond investors, however, recognize Bond investors, however, recognize that the rising or lowering tide will that the rising or lowering tide will create the “opportunity universe”create the “opportunity universe” e.g. “I can’t achieve a 10% return if e.g. “I can’t achieve a 10% return if

interest rates are 3%”interest rates are 3%”


Examples of Risk-Return Examples of Risk-Return TradeoffsTradeoffs


What Drives Market What Drives Market Prices?Prices?

Fundamentals Fundamentals Economic Cycle; Economic Cycle; Corporate Earnings (S&P 500 at Corporate Earnings (S&P 500 at $90/share in earnings)$90/share in earnings)

Liquidity Liquidity Availability of capital; money Availability of capital; money flow; Fed policy can influence thisflow; Fed policy can influence this

Investor Sentiment Investor Sentiment Enthusiasm drives Enthusiasm drives P/E ratios for stocks; Yield spreads for P/E ratios for stocks; Yield spreads for bondsbonds


Managing Risk with Sector Managing Risk with Sector CyclesCycles


Market CyclesMarket Cycles Markets move in broad cycles driven by a Markets move in broad cycles driven by a

combination of fundamentals and sentimentcombination of fundamentals and sentiment SECULAR cycles last 15-20 years, typically SECULAR cycles last 15-20 years, typically Subcycles last 2-3 years, typicallySubcycles last 2-3 years, typically

Most stocks follow the marketMost stocks follow the market Secular cycles peak when investor Secular cycles peak when investor

sentiment (good or bad) reaches a “fever sentiment (good or bad) reaches a “fever pitch” pushing prices well beyond norms.pitch” pushing prices well beyond norms.

Subcycles change more on Subcycles change more on events/fundamentals – e.g. perceived events/fundamentals – e.g. perceived economic expansion/recessioneconomic expansion/recession


Secular Market CyclesSecular Market Cycles

Secular bull cycle – i.e. 1982-2000 for Secular bull cycle – i.e. 1982-2000 for stocksstocks Investment rarely loses moneyInvestment rarely loses money Pricing reaches very high levelsPricing reaches very high levels

P/E ratios for stocks are a good general barometerP/E ratios for stocks are a good general barometer

Secular bear cycle – i.e. 2000-today for Secular bear cycle – i.e. 2000-today for stocksstocks Investment struggles to deliver real returnInvestment struggles to deliver real return P/E ratios gradually slope downward to under P/E ratios gradually slope downward to under

1010


Investing in Secular BullInvesting in Secular Bull Buying and holding stocks worksBuying and holding stocks works

Not surprising that much of the buy-and-hold mantra Not surprising that much of the buy-and-hold mantra comes from studies conducted during these periodscomes from studies conducted during these periods

Aggressiveness defined by sector and/or Aggressiveness defined by sector and/or leverageleverage Risk of loss from broader market, over anything Risk of loss from broader market, over anything

beyond a few months, is rare and temporarybeyond a few months, is rare and temporary More standard deviation should generally equal More standard deviation should generally equal

better return because market is moving higherbetter return because market is moving higher


Investing in Secular BearInvesting in Secular Bear

Investment opportunity lies in market swingsInvestment opportunity lies in market swings Called Tactical investing – recognizing tendency Called Tactical investing – recognizing tendency

for market to move sharply up and downfor market to move sharply up and down

Key becomes recognizing market subcycles Key becomes recognizing market subcycles and moving to cash/short when negativeand moving to cash/short when negative Market offers lots of yearly standard deviationMarket offers lots of yearly standard deviation

Tactical Asset Allocation and simple timingTactical Asset Allocation and simple timing


Identifying Changes in Identifying Changes in Subcycle Subcycle

Definitions (During Secular Bear Market):Definitions (During Secular Bear Market): Cyclical Bull market – 2-3 year trend higher Cyclical Bull market – 2-3 year trend higher

marked by market “corrections” of 10-15%marked by market “corrections” of 10-15% Cyclical Bear market – 2-3 year trend lower Cyclical Bear market – 2-3 year trend lower

marked by counter-trend rallies of 10-15%marked by counter-trend rallies of 10-15% Do not pay attention to earnings!Do not pay attention to earnings!

Market cycle will peak before earnings doMarket cycle will peak before earnings do Pay attention to market behavior:Pay attention to market behavior:

Which sectors are outperformingWhich sectors are outperforming Whether investors are buying or selling risk Whether investors are buying or selling risk

high yield bonds as a market “tell” high yield bonds as a market “tell”


Simple Timing Simple Timing MechanismsMechanisms

50-200 Simple or exponential moving average50-200 Simple or exponential moving average


Results from Simple Results from Simple TimingTiming


Using ETFs to Implement Using ETFs to Implement Tactical Stock Market Tactical Stock Market

StrategyStrategy When the Subcycle bear market trigger is When the Subcycle bear market trigger is

hit:hit: Can exit all stock positions and transition into Can exit all stock positions and transition into

bondsbonds Can hold favored long-term stock positions but Can hold favored long-term stock positions but

hedge themhedge them Hedge them using inverse ETFs, such as Hedge them using inverse ETFs, such as

SH/DOGSH/DOG or more specific sectors, if applicable or more specific sectors, if applicable E.g. own XOM, hedge with DUG (inverse large-cap E.g. own XOM, hedge with DUG (inverse large-cap

energy)energy) 2x/3x inverse can be used for brief periods, but 2x/3x inverse can be used for brief periods, but

negative compounding makes them less negative compounding makes them less desirable.desirable.


Cyclical Downtrend Cyclical Downtrend PortfolioPortfolio

Expect 18-24 months of higher volatility Expect 18-24 months of higher volatility and general downtrendand general downtrend

Core holding of BND/AGG or similar (or Core holding of BND/AGG or similar (or cash)cash) Focus is on protecting assets and generating Focus is on protecting assets and generating

low-risk yieldlow-risk yield

Being aggressive Being aggressive Add short positions (DOG, SH) Add short positions (DOG, SH) Play sharp counter-trend rallies Play sharp counter-trend rallies


Cyclical Uptrend Cyclical Uptrend PortfolioPortfolio

A cyclical uptrend suggests we can A cyclical uptrend suggests we can safely take more risk.safely take more risk.

Uptrend should last for 2-3 yearsUptrend should last for 2-3 years

Core Stock Holding of VTI Core Stock Holding of VTI Add some punch with IJK and/or IWO Add some punch with IJK and/or IWO If international is strong, EFA and/or If international is strong, EFA and/or

EEMEEM Use High yield bonds for bond pieceUse High yield bonds for bond piece


Down/Upshifting a Down/Upshifting a PortfolioPortfolio

We can also take half-steps in We can also take half-steps in making our portfolio more tacticalmaking our portfolio more tactical

Reduce our risk by adding more Reduce our risk by adding more yieldyield

Move from stock index position toMove from stock index position to1.1. High yield stock ETF (DVY or SDY)High yield stock ETF (DVY or SDY)2.2. Preferred stock ETF (PFF/PGX/PGF)Preferred stock ETF (PFF/PGX/PGF)

Note: mostly financial companiesNote: mostly financial companies

3.3. Hybrid yield ETF (PCEF)Hybrid yield ETF (PCEF)4.4. High yield bonds (HYG/JNK, VWEHX)High yield bonds (HYG/JNK, VWEHX)5.5. Corporate bonds (LQD)Corporate bonds (LQD)

Decre

asin

g

Risk


A Different ApproachA Different Approach

Take a Core-Satellite ApproachTake a Core-Satellite Approach Use Asset Allocation Funds as your Use Asset Allocation Funds as your

conservative coreconservative core Will offer some exposure to equitiesWill offer some exposure to equities But manage risk to varying degreesBut manage risk to varying degrees

Favored Asset Allocation Funds Favored Asset Allocation Funds ((instead of a Balanced Fundinstead of a Balanced Fund)) Sierra Core Retirement Sierra Core Retirement SIRIX SIRIX Pimco Asset Allocation Pimco Asset Allocation PAAIX PAAIX


Core-SatelliteCore-Satellite

Up/Downshift the Satellite based on Up/Downshift the Satellite based on market cyclemarket cycle

In an UptrendIn an Uptrend use the higher-beta use the higher-beta choiceschoices VWEHX, FSICX, FLVCXVWEHX, FSICX, FLVCX

In a DowntrendIn a Downtrend use the defensive choices use the defensive choices PTTRX, BND, inverse ETFsPTTRX, BND, inverse ETFs


The Impact of InflationThe Impact of Inflation Inflation impacts interest ratesInflation impacts interest rates

Higher inflation = higher interest ratesHigher inflation = higher interest rates Higher interest rates creates competition for Higher interest rates creates competition for

stocksstocks Inflation impacts earningsInflation impacts earnings

Can improve pricing power Can improve pricing power higher margins higher margins Ultimately margins hit a wallUltimately margins hit a wall

Inflation creates anxiety among investorsInflation creates anxiety among investors Lowers their “sentiment”Lowers their “sentiment”


Building an Investment Building an Investment StrategyStrategy

ObjectivesObjectives Long-term (retirement) vs Short-term Long-term (retirement) vs Short-term

(project)(project)

Personality ProfilePersonality Profile Knowledge Knowledge MaintenanceMaintenance Stomach (Ability to Handle Volatility)Stomach (Ability to Handle Volatility)


To SummarizeTo Summarize Understanding where we are in broad market cycles Understanding where we are in broad market cycles

should frame our investment strategy.should frame our investment strategy. There are decades+ secular cycles and 2-3 year There are decades+ secular cycles and 2-3 year

subcycles, the combination of which drives our subcycles, the combination of which drives our investing approach.investing approach.

ETFs have dramatically enhanced our ability to take ETFs have dramatically enhanced our ability to take advantage of market cycles, both to profit from them advantage of market cycles, both to profit from them and protect against losses.and protect against losses.

We have entered into a new bear market where caution We have entered into a new bear market where caution is the watchword. We expect stocks to be generally is the watchword. We expect stocks to be generally weak with occasional rallies for the next 12-18 months. weak with occasional rallies for the next 12-18 months.

This market will offer good values during this process This market will offer good values during this process for buy low-sell high, traditional investing.for buy low-sell high, traditional investing.

Tactical investing is another way to manage through Tactical investing is another way to manage through these cycles. these cycles.


What About Gold?What About Gold?

investing in bull and bear markets: what’s the difference?

Documents

sector funds

mutual fundsmutual funds

stocks trade

bondsmanaging risk

expected return

typicallymost stocks

passive equationfidelity

passive index