Markets Update: Playing Defense

Global equity markets have declined beyond a normal correction in recent weeks and our Active Risk Management process is fully engaged. As you know, this is a process intended to limit catastrophic bear market losses by reducing your stock exposure, and your risk, prior to a steeper, prolonged decline. Keep in mind that recessionary bear markets often decline between 40-60% – more than twice the decline markets have already experienced. It is important to note that your portfolio now has much less than its earlier stock exposure, which has helped quite a bit during this most recent selloff, where stock indexes have declined significantly. Is the economy going to tip into a recession and send stocks further down? How long will that take? Let's discuss.

The Problem – Inflation

As we have written previously, the vaccines and fiscal/Fed policy during Covid created an economic boom, producing growth rates three times as strong as anything seen in the past 20 years. We now have an economy growing at 6% in a world that was accustomed to 2% - creating a demand shock for goods and services and a whopping 8.5% inflation rate. Inflation is the problem – as prices soar, personal incomes get compressed, which is very damaging to consumer health and the economy. Therefore, the Federal Reserve and other global central banks need to unwind their previous generosity of low rates and accommodation to slow economic growth and demand, so that supplies and services can "catch up." This is no easy task, particularly with the added dynamic of war in Ukraine exacerbating the inflation problem. Can the Fed raise rates just enough to slow the economy and cool inflation to create a "soft landing?" It’s going to be a very difficult needle to thread and markets are signaling that doubt by falling more than normal – discounting that a recession may be inevitable to quash inflation. If this comes to fruition, stock prices will fall much further – hence our defensive posture of much less stock exposure and continued use of close stop losses on your remaining stocks. At this point, the declines we have experienced, though uncomfortable, are recoverable in the eventual market upturn and we want to keep it that way – hence our mode of playing defense.

How Long do Bear Markets Last? Not as Long as You’d Think

We would suggest that we are in a bear market – a period when stocks drop more than 20% and for an extended period of time. However, it is very important to recall that bear markets don’t last years but months. Historically, the average bear market lasts about nine months, with the longest lasting 14 months (2008). The bulk of bear market declines often come to fruition before the recession actually occurs – as investors start discounting the possibility by selling shares – similar to what we are seeing this year. In the same spirit, stocks typically start recovering in the middle of a recession – discounting the end of the recession and the beginning of a new business cycle. This history reminds us that we may already be in our fifth month of this bear market, or likely halfway through – and maybe halfway down. Keep in mind that we may temporarily keep cash balances or short-term treasuries during this period – this is the "dry powder" we will need to reinvest in a recovery.

Playing Defense

The best way to defend against these falling markets is to have less stock exposure – which we have achieved. Additionally, it is important that the remaining stock exposure is in recession-resistant sectors such as healthcare and consumer staples. Lastly, we have stop loss orders within a close range even on these more defensive stock holdings, just in case, there is pervasive selling pressure throughout the market.

The Light at the End of the Tunnel

Things can turn for the better if inflation begins to fall on its own, the Fed decides to be less aggressive about raising rates, or the war in Ukraine is resolved. We don’t have much faith in any of these occurring anytime soon, but we are prepared to reinvest should we get the "green light" that the coast is clear. As we always say in our team meetings, "reinvesting we can do quickly but recovering from catastrophic decline can take years!"

The Real Cost of Selling – Taxes

None of us enjoy paying Uncle Sam taxes on capital gains, however, it is a necessary expense to help protect your portfolio from a catastrophic decline. As a client recently stated, "The capital gains we pay is like an insurance premium against a catastrophic decline" – thank you JC for this simple way to understand the concept. In 2008, we had to sell a significant amount of stock exposure to avoid the 55% decline witnessed in indexes. Most clients had a tax bill that represented between 2-4% of their portfolio value – a much better outcome than allowing the portfolio to be cut in half in addition to the seven years it took indexes to return to their previous levels. An important reminder for you is that we always consider that the portfolio pays its way through the capital gains pinch so we will be reserving cash balances in your portfolio for the inevitable tax bill. For more on this subject, please click this link.

If the Market gets Worse, Should I "Short" Stock Sectors?

An additional risk management strategy that we have used in past times of market stress is the ability to sell stock short. We do not discuss short selling as often because it is rarely used compared to our other ARM strategies, but it involves borrowing a stock or ETF, selling it, and buying it back at a later date. When the underlying position or index falls in value, the short position rises in value. This inverse tool can provide a hedge in turbulent times. We view having this option as your investment manager as a good one should we deem it appropriate. If employed, the position would not represent a significant amount of your portfolio. We would use a stop loss order to prevent the risk of the underlying position increasing in value, hence decreasing the value of the short position. Selling stock short in this fashion can only be done in a taxable account with margin features enabled. Please keep in mind that this proactive preparation is another tool we want available for potential further downside risk – we are not at the point now to short sell stock

The Eventual Market Recovery – Not to Be Missed

At some point – hopefully, sooner than later – inflation will be tamed and global equity markets will present a great entry point to reinvest. Keep in mind the best time period of a bull market is the first 18 months. Often during this first phase, indexes rise by 20% or more and it’s not an opportunity to be missed. Our research suggests that this recovery phase is not yet imminent. However, we are in the process of building our "recovery portfolio" of some excellent companies that we think will lead in the ensuing bull market ahead. Many of these prices have already been beaten down and any further declines will make them very compelling purchases. It is exciting for our team to look past this "valley of doom" to what we know will be an amazing recovery with better economic fundamentals.

It’s a complex market and economy and our defense is in play. Should stock indexes continue to decline your portfolio will be cushioned by less stock exposure, defensive sector exposure, and the stop loss orders that remain in place.

Thank you again for your continued votes of confidence in our work!


Short Sales: We borrow shares of a stock for your portfolio from someone who owns the stock on a promise to replace the shares on a future date at a certain price. Those borrowed shares are then sold. On the agreed-upon future date, we buy the same stock and return the shares to the original owner. We engage in short selling based on our determination that the stock will go down in price after we have borrowed the shares. If we are correct and the stock price has gone down since the shares were purchased from the original owner, the client account realizes the profit.

Short selling results in some unique risks:

1.   Losses can be infinite. A short sale loses when the stock price rises, and a stock is not limited (at least, theoretically) in how high it can go. For example, if you short 100 shares at $50 each, hoping to make a profit but the shares increase to $75 per share, you'd lose $2,500. On the other hand, the price of a stock cannot fall below $0, which limits your potential upside.

2.   Short squeezes can wring out profits. As stock prices increase, short seller losses also increase as sellers rush to buy the stock to cover their positions. This increase in demand, in turn, further drives the prices up.

3.   Timing. Even if we are correct in determining that the price of a stock will decline, we run the risk of incorrectly determining when the decline will take place, i.e., being right too soon. Although a company is overvalued, it could conceivably take some time for the price to come down; during which you are vulnerable to interest, margin calls, etc.

4.   Inflation. History has shown that over the long term, most stocks appreciate. Even if a company barely improves over time, inflation should drive its share price up somewhat. In fact, short selling may not be appropriate in times of inflation for that very reason, as prices may adjust upwards regardless of the value of the stock.