Investing In A Turbulent Market
Summary In turbulent times, investors need a plan and stick with a few basic rules. Assess macro conditions to guide investment decisions. Recognize the fact that danger and opportunities usually go hand in hand. Actively tweak winning odds to our favor as frequently as we can. It’s been two months since I left my role as a systematic global macro manager to focus on a few equity strategies I have been developing over the past few years. The timing was not great as world equities have been in a tailspin. Many blame China, the US Federal Reserve, and anemic world economic growth as the causes of the selloff. To me, they are just excuses. The real culprit of the market downturn is the investor jitters. Disciplined investors should follow some basic principles for investing in a turbulent environment. Here are some rules I follow: 1. Assess macro conditions to guide investment decisions 2. Recognize the fact that danger and opportunities usually go hand in hand 3. Actively tweak winning odds to our favor as frequently as we can. Assessing Macro Conditions to Guide Investment Decisions An old saying “rising tide lifts all boats” has found new meaning in stocks since 2009. Central banks around the world injected trillions of dollars into the world financial system. Ample money supply is undeniably one of the most important reasons for the current equity bull market. An equity investor should have done well if he recognized this simple macro factor. Therefore, accurately assessing the global macro environment is instrumental in performance. Differing opinions of economic conditions are the root cause of investor anxiety. So where are we now? China, as the world economic growth engine for the last decade, is facing some headwinds. It needs to absorb the excess from multi-decade economic expansion, rein in speculation, transition its economy from low-cost manufacturing to service and consumption, and steady investments and long-term growth to a sustainable level. Such a transition is not going to be easy and painless at all times. As someone who grew up in China before the reform began in earnest, I often found investors not giving enough credit to the success of China’s economic policies that has elevated a poor country with food rationing to a world economic powerhouse. Over the past 20 years, there were many calls of hard landing in China by market “gurus,” but none materialized. There is a certain arrogance to those calls. Is China facing hard landing again this time? I doubt that! Just as we like to say in the West “quiet water runs deep,” people in the East like to say, “narrow water runs far.” Publicizing policies has never been a strong suit of running things in China. Nevertheless, I believe China has economic means and a deep bench of highly skilled policy makers to navigate choppy waters. Everyone can make mistakes, but so far, there is no indication that China won’t be successful again in turning the ship around this time. In my view, they are proactively using policy tools to minimize the negative impact in a changing world. Investors are fickle. Before the two-day US Federal Reserve policy meeting last week, futures market implied a 30% chance of an interest rate hike in September. The market was right, the Federal Reserve did not hike interest rates. At the same time, investors reacted poorly to the decision as the US dollar sold off and interest rates dropped immediately after the announcement. Was the decision a surprise or was it expected? Investors cannot make up their mind. In my view, the timing of the Fed rate hike is not that important. There is no urgency to a rate hike in the absence of inflationary pressures. Nevertheless, barring significant economic deterioration, we will get a rate hike in December. Otherwise, Chairman Yellen’s credibility will be at risk as she previously indicated a hike this year. Given that outlook, I suspect both US dollar and interest rates will trade higher in the next two months. Moreover, according to some studies, a 25 basis points hike will only roughly translate into a 0.1% decline in GDP growth. There is simply no reason to be fixated on that. Accurate macro assessments can not only help us achieve long-term profitability, but also guide our short-term trading. A number of recent selloffs in global equity markets were in sympathy to selloffs in the Chinese equity market. Given the Chinese National Day is coming on October 1, an imminent meltdown in China is almost impossible. Therefore, any significant selloff could create short-term buying opportunities. Recognize the Fact that Danger and Opportunities Usually Go Hand in Hand Novice investors tend to chase markets and hang on to losers too long. It is much better to pick up quality names in a down market when everyone else is selling. In addition, losers tend to go down less than quality names precisely because some investors cannot psychologically part with losers, and instead sell stocks with gains to raise funds during a market downturn. Do not be afraid of selling losers! Better yet, pick up some winners in a down drift by selling losers for harvesting capital losses to reduce realized capital gains. Furthermore, global economic conditions are getting better, not worse – Europe is finally getting ahead of its sovereign debt crisis, the US economic growth is intact, China is working out short-term pains for long-term gains, the weak energy price should largely be stimulative to growth, and global monetary policies will remain accommodative for the foreseeable future. Therefore, there are opportunities to be had in the current passing danger. Actively Tweak Winning Odds to Our Favor as Frequently as We Can I consider myself as a long-term investor as I look to profit from fundamental research and typically hold stocks for an extended period of time. Fundamentals never play out overnight. However, I question the effectiveness of the “buy, hold and do nothing” strategy in the current market environment where information is so readily available through the internet, media, and social networks, affecting investor psyche constantly, and generating market volatility. Because of daily marks to market, professional hedge fund managers cannot sit idle and do nothing during market turbulence. I would argue that individual investors who look after their own portfolios should also be actively looking for ways to increase winning odds by using available tools such as listed equity options. Here are a few suggestions: a. If one wants to buy 100 shares of stock XYZ, he can sell one contract of put option at a strike price lower than or close to the current stock price. At maturity, if the stock price is higher than the strike price, one gets to keep the put option premium; otherwise, one acquires the stock at a price lower than the current price. b. When a stock in a portfolio has appreciated significantly, one should consider selling some covered calls to lighten up the load. At maturity, if the stock price is higher than the strike price, one effectively sells the stock at the strike price plus option premium; otherwise, he gets to keep the option premium. c. In fact, instead of following the red-hot “dividend investing” strategy, a) and b) can be viewed as a “create-your-own-dividend” strategy on any stock. With weekly options, one can aim to generate 10% annual yield by selling options. That’s 10% income and/or cushion one doesn’t have if he does nothing. d. During a market downturn, instead of buying quality stocks outright, one can buy calendar spreads, i.e. buying long-term calls against selling short-term calls at appropriate strikes to further reduce risk. e. Shorting high beta, richly valued stocks can be a more effective hedge than shorting index futures in the portfolio. There are many strategies that can be deployed day in and day out to generate consistent returns or opportunistically in turbulence when everything is out of whack. But one should always have a plan to deal with different market conditions and follow a set of rules so that he is not caught off guard. Let me know what you think. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.