National Post (National Edition)
BATTLE FORMATIONS
Three strategies to use, or three to avoid, during a correction.
The fun part about a father-son medieval camp I attended last week had the fathers dressing up like evil bad guys in full body armour and challenging the sons in a number of epic battles that included water balloon catapults, Clarence the Destroyer battering ram and fog machines.
Both the fathers and sons were taught offensive and defensive battle formations and strategies that at times were quite effective while others proved disastrous — albeit mostly for the fathers.
Some investors and pundits, likewise, have been acting offensively by buying the dips while others have decided to be defensive by moving to the sidelines paralyzed by all of the market noise.
Like battle formations, it is best to look to history to see which ones work and which ones have failed when executed properly. In particular, for those worried about what lies ahead, there are three oftenused defensive strategies that have proven quite ineffective in the past but continue to receive a lot of attention: gold, international stocks and stop losses.
Some pundits have been promoting the gold trade for decades, citing their concerns over nonexistent hyper-inflation and the fallout from all the money printing by the U.S. Federal Reserve. As a result, gold has often been touted as the go-to defensive trade in a correcting market.
However, the evidence is quite contrary when looking back at previous corrections. For example, in the 2008/2009 financial crisis, gold prices actually fell about 25%. Gold stocks did even worse, falling a whopping 56% from peak to trough over the same period.
International equities should be a core part of any investment portfolio as highly concentrated domestic portfolios will at times miss out on better-performing markets abroad, especially in a global recovery. Simply look at the outperformance of the U.S. equity market compared to Canada since the bottom in 2009.
That said, it is equally important to realize that international diversification will do little to protect a portfolio during a correction due to rising correlations among global equity markets.
For example, the S&P/TSX lost 45% from peak to trough during the financial crisis, but the S&P 500, MSCI EAFE Index and MSCI Emerging Markets also lost 44%, 51% and 56%, respectively.
Finally, there are advisors utilizing strategies of old such as stop losses that are no longer effective because of the implementation of new electronic trading platforms and high-frequency traders (HFT).
Stop losses no longer work in today’s market environment because there are HFT’s specifically designed to spot such trades, purposely stop them and then bid the stock back up again. During a fullblown correction, stop losses will often be blown through with little to no execution.
The good news is there are some strategies that have proven very effective.
For example, investors should always own a portion of bonds in their portfolios. Despite the potential exposure to rising interest rates and the current low yield environment, history has shown bonds will preserve capital and appreciate during periods of market instability.
History has also shown that the U.S. dollar is a safe-haven currency and, therefore, U.S. dollar treasuries and government bonds have performed quite well during corrections.
For example, the dollar rallied 28% against the loonie during the 2008/09 correction, while shorter-term (one to three years) U.S. Treasuries rallied approximately 4% and longer-term Treasuries (seven to 10 years) rallied 17%.
That said, investors may wish to limit their duration exposure, thereby sacrificing some yield, in order to factor in the low-yield environment and mitigate the risk of rising rates against the risk of a correction.
Finally, derivative strategies such as buying puts have been very effective in protecting a portfolio. Put prices have fallen because market volatility has reached new lows, so the cost has dropped to insure the equity component of a portfolio.