Investing in Uncertain Markets

Presentation to AAII

Baton Rouge Chapter Meeting

April 2014

INVESTING IN UNCERTAIN MARKETS

DON LANSING (DON@LANSINGINVESTMENTS.COM) 2

BEARS (going into 2013):•Without the Fed, this market falls apart, because …•The global economy is buried under the weight of debt•Deleveraging (reducing the debt) cycle will keep earnings and investor sentiment down•Eurozone workouts and China slowdown are big known risks.•U.S. budget issues and related debt are a big potential risk The Fiscal Cliff!

What a DRAG!

THE IMPACT OF GLOBAL DEBT

• Living in Reinhart/Rogoff World:• Research by Reinhart/Rogoff widely sited for concerns about U.S.

• Studied financial situation of 44 countries over two centuries

• Found that debt to GDP >90% was a tipping point

• Led to reduction in growth of -1% for years on end (20+ years)

• Why? Limits government’s ability to invest

• Resources going to pay down/support debt

• Interest rates spike as markets demand more compensation

BUT THE RULES DON’T APPLY TO THE U.S. … YET

• Is the U.S. different?• Yes – for now.

• Almost unlimited ability to borrow, and very cheaply!

• Reserve currency and related Treasury bond market provide important “buffer” – size of markets without peer

• Debt has been transferred from private to public – lowers net interest expense in the “system”

• Debt supporting investment is preferential to debt supporting consumption – “hello Greece”

• It gives us the “freedom to be irresponsible”

Government spending growth grinds to a halt

CONSUMERS DE-LEVERAGE

DON LANSING (DON@LANSINGINVESTMENTS.COM)

@parhedge Be LONG insanity and SHORT common sense

How common is it to have a 10%+ intra-year decline?

WHAT DRIVES MARKET PRICES?

• Fundamentals Economic Cycle and Corporate Earnings

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

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

Corporate Earnings x PE Ratio = Market Prices

And then THIS Happened …

CORP PROFITS TAKE FLIGHT IN 2013

INTO THE GREEN – EUROPE BEGINS TO RECOVER

BOND INVESTORS GET SHOCKED

QE SPARKED A FLOOD OF MONEY INTO BONDS

What if only a fraction of that bond wave flows back into stocks?

19DON LANSING (DON@LANSINGINVESTMENTS.COM)

“The stock market is all about money. Money goes in and the stock market goes up. Money flows out and the stock market goes down.”

– Jesse Livermore

Asset Allocation Funds have a poor year

BEARS: FALLING LIKE DOMINOS

• “I have been prepared to underperform for the fun of being proved right when markets crash. But that could be in three-and-a-half-years’ time.”

• “I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends.”

• “I am out of justification to fight the uptrend. Up until now, I have had what I thought was compelling evidence to believe in the bearish case, but it has now been revealed to have been insufficient for the task.”

20%+ Returns are Common

Compared to Historical Rallies

THIS BULL MARKET JUST WON’T STOP!

Been a long time …

WHAT IS “NORMAL”?

“In the average bull market, the S&P 500 falls by 10% or more every 16 months. It has now been over 31 months since the last such pullback. Investors have forgotten what a normal market looks like.”

– CIO of $130B firm

What is “normal”?

ARE STOCKS EXPENSIVE?

NOT COMPARED TO RECENT PRIOR PEAKS

Nor Compared to Projected Earnings

Compared to Historical Rallies

2014 – the Road to Nowhere?

2014 SO FAR – STATE OF GLOBAL ECONOMIES

2014 SO FAR: IMPACT ON THE SECTOR PLAYBOOK

2014 SO FAR – SIMPLE MEAN REVERSION

Will Higher Interest Rates kill the rally?

And Stocks do fine

Spending Changes As We Age

How to invest in a rising rate environment?

What bonds are best in a rising rate environment?

MANAGING INCOME PORTFOLIOS

• Importance of Duration• +1% move in interest rates = -D% move in bond price

• Managing spreads instead of rates• Spread = Difference between rate of bond & Treasury rate• Higher the spread, the more compensation being demanded• Lower spreads = nearer to end of cycle• Watch spreads for clues about the end of the cycle!

Dealing with Uncertainty

WHY THE UNCERTAINTY?

“Here is the simple reality we try desperately to ignore: Most of the time, we have no idea what is going on.”

– Barry Ritholtz

THE BENEFIT OF NOT PAYING ATTENTION

WAYS TO MITIGATE RISK – INCREASE DIVERSIFICATION

DEALING WITH UNCERTAINTY – SIMPLE TIMING

Avoid the bad times.

Keep vol low.

DEALING WITH UNCERTAINTY:PORTFOLIO CONSTRUCTION – COMBINING IDEAS

• Carry a low-volatility core portfolio• Can be low-volatility stocks and/or bonds

• Bonds can be adjusted for risk target – e.g. HY

• “Allow” allocation to higher performance/volatility pieces when applicable• When market trending up – own higher-beta pieces

• Market volatility increases – cut high-beta positions

DOWN/UPSHIFTING A PORTFOLIO

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

• Reduce our risk by adding more yield• Move from stock index position to

1. High yield stock ETF (DVY/SDY/HDV/SDIV)

2. Convertible bond ETF (CWB)

3. Hybrid yield ETF (GYLD/INKM, PDVYX)

4. High yield bonds (HYG/JNK, VWEHX)

5. Corporate bonds (LQD)

Decreasing Risk

HEDGING YOUR PORTFOLIO WITH OPTIONS

• Buy Index Put Options• Go x% out of the money with some time (3 months)• Use most volatile indexes – e.g. Russell 2000• $130 for a 3-month 10% OTM option – will rise 3x • Take your gains! (and roll over)

• Sell VIX Put options – need to sell a lot to offset total portfolio risk (each option may generate $30)

• Sell Index Call Options – helps for short-term/pair with buying puts

A STRATEGY FOR ADDING RETURN

DEALING WITH UNCERTAINTY:A PORTFOLIO ADDER

• Sell VIX Options at “edges”• Sold Puts go up as market drops – a reasonable ongoing

• Sold Calls go up as market rises

• “Cash-settled” options• All that matters is the expiration close of the VIX

• Pocket almost ALL of your premium

• Downside = $100/contract per point

MISCELLANEOUS NOTES

• Markets rarely STAY down on geopolitical issues • BUY THEM!

• Markets do not STAY down without a recession• There is none in sight

• The “normalization” of markets will increase volatility and create opportunities

• Brokers like: Europe (recovering and cheap)• U.S. Large Caps (small-caps have become expensive)

• Always watch High-yield bonds for a market signal

TO SUMMARIZE

• Investors became far more comfortable in 2013.• This resulted in a rush toward equities as it became more expensive

to be out of the market than in.• The question is whether this is a calm before another market storm or

the end of a decade-long secular bear market • Europe and China remain uncertain though appear to be improving• We don’t know how stock markets will react to the end of the Fed’s

bond buying program.• There are ways to substantially lessen volatility while still achieving

solid returns.• Remember what matters – positive economic growth and generally

positive sentiment – not political noise, nor nebulous forecasts of doom

IS THIS BULL JUST BEGINNING TO RUN?

"Every day I get up and look through the Forbes list of the richest people in America. If I'm not there, I go to work. " -Robert Orben

THANK YOU BATON ROUGE!

Backup

BUILDING AN INVESTMENT STRATEGY

• Objectives• Long-term (retirement) vs Short-term (project)

• Personality Profile• Knowledge

• Maintenance

• Stomach (Ability to Handle Volatility)

DISCUSSION OF RISK

• What is risk? A result that is different than expected – investors focus on worse than expected. • Volatility is the enemy of successful investing (though it also

creates opportunities)

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

• Deviation from account peak – what we call “drawdown” – is a key focus• Investors emotionally “own” an asset value

• Thus, the goal is to minimize drawdown and hold on to the bulk of gains offered

69DON LANSING (DON@LANSINGINVESTMENTS.COM)

2-3 Years Up; 1-2 years Down

BEARS:•Without the Fed, this market falls apart, because …•The global economy is buried under the weight of debt•Deleveraging (reducing the debt) cycle will keep earnings and investor sentiment down•Eurozone workouts and China slowdown are big known risks.•U.S. budget issues and related debt are a big potential risk.

Are we in the middle of a long-term bear market?

Investing in Uncertain Markets

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