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How to Invest in Highly Volatile, Uncertain Markets
Considering the wild swings in worldwide stock markets over the last several months, I am focusing my comments this quarter on how to invest in highly volatile, uncertain markets. Below, I will list four keys to successfully navigating these turbulent times.
Key #1: Remain Diversified: When markets move with greater volatility, investors commonly flock to investments that have performed the best over the most recent period. By chasing the best performing asset class, investors add risk to the portfolio by placing too much emphasis on any one investment. Many times, these investments are added to the portfolio after the asset class has risen significantly. By so doing, the investor reduces exposure to the undervalued assets in the portfolio while adding to the overvalued assets…..therefore creating greater risk of loss. By remaining diversified when the future is unpredictable, an investor is likely to keep portfolio risk / volatility lower.
Key #2: Know your time horizon: As short-term movements in the market (both up and down) are bound to happen, an investor must be aware of his or her time horizon, particularly in turbulent times. If there is a significant cash need from the portfolio within the foreseeable future, actions must be taken to reduce the portfolio risk/volatility. However, if there is a much longer time horizon, the investor must focus on the long-term plan. Short-term movements in the market typically have very little effect on a portfolio’s return over longer periods (20-30 years). If you are a long-term investor, avoid making rash decisions that could significantly alter your long-term goals (Example: Stopping your contributions, timing the market, etc.).
Key #3: Focus on Defensive Sectors: During uncertain, volatile markets, defensive sectors can help stabilize the volatility in your portfolio because their earnings are quite consistent in any market environment. Both Health Care and Utility companies are commonly seen as defensive categories as poor economic data does little to affect their company earnings. Common defensive stocks are Johnson & Johnson, Proctor & Gamble, and as of recently, McDonald’s. I am constantly impressed by McDonald’s ability to offer a product to a consumer at a lower cost than if the consumer went out and bought the supplies themselves. Let’s face it, families enjoy eating out…and when times are tough, they opt for the least expensive option. Defensive Sectors pay higher than average dividends to their investors. As such, these investments provide added income into your portfolio (as will be discussed in Key #4).
Key #4: Increase Portfolio Income: Portfolio volatility can be greatly reduced by focusing on income-oriented investments. Look for companies who provide high dividend payouts. Even when stock prices fluctuate, you are able to collect consistent income for the portfolio. Increased exposure to fixed income (bonds), preferred stock, Real Estate Investments Trusts, and high dividend-paying stocks will give you the added income you need to provide more consistent returns.
Season’s Greetings
Thank you to all of our valued clients for your continued business! May you and your families have a blessed holiday season!
Third Quarter 2011 Market Analysis
Although the 3rd quarter performance for the S&P 500 has been less than favorable (and quite volatile), it may be helpful to look at historic performance trends for the index as we enter the latter part of the year. In the last 20 years (1991-2010), the S&P 500 stock index has gained more on a total return basis during the 4th quarter (i.e., October-November-December) than it has during the other 3 quarters combined. The final 3 months of the year have gained 150.9% (total return) vs. a gain of 129.2% for the first 9 months of the year over the last 2 decades (source: BTN Research). Furthermore, the best monthly performance on a total return basis for the S&P 500 over the last decade (2001-2010) has occurred in April, October or November in 9 of those 10 years. The only year that 1 of these 3 months did not lead the way was in calendar year 2010 when September was the best month (source: BTN Research).
As we ponder the various reasons for the weak market performance over the last two months, perhaps the most recent explanation can be attributed to a revised economic growth forecast from top economists with the National Association for Business Economics. In their latest forecast, the economists predict that the U.S. economy will grow 1.7 percent this year — down from the group’s May prediction of 2.8 percent expansion. For 2012, the group is forecasting growth of 2.3 percent, compared to a May forecast of 3.2 percent growth. In these slow-growth, uncertain times, I continue to recommend the use of higher yielding investments in a client’s portfolio. These assets can help reduce portfolio volatility and provide a stable income stream. As always, if you have any questions regarding your plan for the upcoming year, please give me a call at your convenience.
Second Quarter 2011 Market Analysis
Over the last several weeks, I’ve heard several commentaries offering their forecasts for the direction of our economy. In April, I had the opportunity to attend a conference sponsored by Curian Capital Management in Newport Beach, CA. The event was held at PIMCO’s home offices and featured presentations from several of their top investment analysts. At one point, we even had a surprise visit by Bill Gross, fund manager of the PIMCO Total Return Fund (the largest bond fund in the world). Bill discussed the Fed’s current low interest rate policy, a strategy Bill calls, “Financial Depression.” Financial Depression occurs when interest rates are kept lower than the actual rate of inflation. By so doing, the Federal Reserve hopes to grow its way out of our tremendous national deficit. This strategy ultimately causes a devaluation of our currency which may lead to higher future inflation. As such, the PIMCO fund managers are finding value in holding real assets like precious metals, energy stocks, and commodities. These assets can help hedge against a weakening dollar. Although the U.S. dollar has recently rallied due to renewed concerns over debt problems in Europe, PIMCO’s management believes the dollar will continue its devaluation over the longer-term.
One of our other investment partners, CLS Investment firm, recently held their quarterly investment committee meeting. At the meeting they discussed possible outcomes for the economy over the next three years. As these findings were quite consistent with PIMCO’s analysis, I thought it would be helpful to share some of their predictions for the next few years. In particular, CLS outlined what they thought would go right, and what could possibly go wrong in the years ahead.
2011 Outlook: The economy gradually slows as the year progresses.
This prediction may already have begun to take place. From April 29th, 2011 through June 10th, 2011, the S&P 500 index was down 6.6% due to a series of worse-than-expected economic data.
| What could Go Right? | What could Go Wrong? |
| Employment is rising | QE2 ends and the economy slows dramatically |
| Retail Sales Rising | Oil Rises above $120.00 |
| Leading Indicators Rising | U.S. Dollar Collapses |
| No Signs of Turmoil in the Bond Market | Interest Rates Rise more than 1.25% |
| The government “talking” about deficit reduction | Stock Prices correct more than 15% |
2012 Outlook: Economic Growth Accelerates
| What could Go Right? | What could Go Wrong? |
| Leading Indicators are correct | Oil Rises above $120.00 per barrel and stays there |
| Oil doesn’t exceed $120 until 2013 | Consumer Price Index registers more than 4% inflation |
| Employment continues to rise | U.S. Dollar Collapses |
| Non-residential construction recovers | Interest Rates Rise another 2% |
| Money Supply growth excites retail activity | Housing Situation worse than expected: recovery doesn’t begin. |
2013-2014 Outlook: Recession
Factors that could contribute to the Recession:
- Accelerating inflation puts a halt to any more quantitative easing
- Oil rises above $140 per barrel
- Interest Rates continue to rise
- Taxes are increased as Bush Era Tax Cuts expire
- Financial Pressure and large worldwide deficits take their toll
As you review the information above, please keep in mind that nobody holds the magic crystal ball to predict if, when, or how these events will take place. Please be sure to give me a call if you would like to review how your investment portfolio is positioned to not only meet your investment goals & risk tolerance, but hedge against some of the challenges facing our economy today. I look forward to hearing from you.
Powerful Estate Planning Technique
Considering the upcoming changes to potential Estate Tax law, I figured I would highlight an interesting estate planning technique that can be a powerful tax-saving strategy for the right individual(s). This strategy primarily works well for investors with the following life circumstances:
The individual must:
- Be Nearing, or in retirement
- Have enough retirement savings to provide adequate income during retirement
- Be in good health
- Have a strong desire to pass assets to beneficiaries in a tax-efficient manner
In order to describe the workings of this strategy, I’ve detailed a case study below:
John Smith is age 65, in good health, and retired. He has sufficient assets to maintain a quality standard of living during retirement for his family. John just inherited $250,000.00 from his Father’s estate. Since he doesn’t need to use these additional assets for living expenses, John wants to invest these assets tax-efficiently in hopes of leaving as much as possible to his beneficiaries. (His wife, Judy, is the primary beneficiary, and his two children are the contingent beneficiaries).
John can invest the $250,000.00 into a Variable Annuity with a living benefit rider. This living benefit rider allows John to withdraw 5% annually (or less) from the $250,000.00 investment. As long as he withdraws 5% or less annually, he is guaranteed to receive this income for the remainder of his life. As such, John is guaranteed at least $12,500.00 per year for the rest of his life regardless of market performance ($250,000.00 times 5%). Since he doesn’t need the income and is in good health, John can purchase a Universal Life Insurance policy with the $12,500 annual income. By using the $12,500 income, John purchases a Life Policy Guaranteed through Age 100 with a death benefit equivalent to $658,000.00 (This death benefit amount is currently offered through Genworth Life for a male, age 65, with a preferred health rating).
John simply pays $12,500.00 in annual premium until his death and his beneficiaries receive the $658,000.00 + any remaining balance in the Variable Annuity at that time. The best part of this strategy is that the death benefit proceeds from the life policy are income tax free to the beneficiaries. By keeping within the limits of the annuity contract and not outliving the age 100 limit on the life policy, John’s $250,000.00 investment will be guaranteed to almost triple over his remaining life (or more if the annuity performs well)……best of all, the beneficiaries pay no income tax on the gain in value. Furthermore, if John is concerned about a potential estate tax issue, he could place the life insurance policy in an irrevocable life insurance trust for his children. If John places the life insurance in the trust more than three years before his death, the life proceeds will bypass John and Judy’s estate….therefore avoiding potential estate tax.
If you think this strategy could benefit you, please don’t hesitate to give us a call to discuss further details. Thank you for your continued business with us! We wish you a wonderful 2011!
Third Quarter 2010 Market Analysis
I’d like to address our response to the recent volatility in worldwide markets. Since the market crash in 2008, there has been an increased focus on using alternative investments as a vehicle for providing added diversification to a portfolio. In fact, you may have seen past articles in the KMS client quarterly. Alternative investments include asset classes outside of your traditional investments (stocks & bonds). Alternative investments include commodities, gold and other precious metals, currency, Real Estate Investment Trusts, and managed futures. Since these asset classes have a low correlation to traditional investments, they can help diversify an account and lower a portfolio’s overall risk. Low correlated asset classes typically don’t move in the same manner from one day to the next. As an example, the price of gold might trend up on a day when Largecap U.S. stocks are trending down. Historically, when alternative investments are added to a traditional portfolio the overall volatility has decreased and the returns have increased. (Lower Risk / Higher Reward).
Let’s take a quick look at a case study. Suppose you invest $100.00 into two separate portfolios, and hold the investments for three years. The returns for each of the two portfolios are listed below:
Year 1 Year 2 Year 3 Portfolio Value after three Years
Portfolio A: 20% -30% 40% $117.00
Portfolio B: 8% 8% 8% $125.00
As you will note, Portfolio B had a much more consistent return over the three year period averaging 8% annually. The average annual return for Portfolio A was 10% annually, but there was far greater volatility. As you will note, Portfolio B had the highest value after the three year performance even though it had a lower average annual rate of return. The reason for this discrepancy is that large losses will need a much greater return to get back to the original value. (If you lose 50% on a $100 investment, your account will be valued at $50.00. Now, you will need a 100% return on the $50.00 in order to get back to your original $100.00 investment.
The illustration above should help explain the need for lowered volatility in a portfolio. The use of alternative investments in a portfolio can help your returns look more like Portfolio B (less volatile and more efficient). Today, we have access to many investment tools to get broad exposure to these various alternative investments. We have been recommending them in a number of accounts in order to help stabilize returns during this choppy market. If you are interested in finding ways to add them to your investment portfolio, please give us a call anytime.
