I, like many investors, am glad to be seeing the back of that quarter. The Coronavirus has caused a rapid crash over the last month in most stock markets across the world. This has left the FTSE 100 down 27.9% and the S&P 500 down 22.9% over the last three months. My portfolio hasn’t fared a great deal better at 18.4% down. It doesn’t look like we are quite out of the woods yet.
As I said in my last post, the direct consequences of the containment measures on economic activity and unemployment are of unprecedented magnitude. Hopes of a swift v-shaped recovery seem overly optimistic. It seems more likely that there will be quite severe knock-on effects as consumer confidence is reduced, investment decisions are delayed and bad debt spreads throughout the global economy. Judging from previous recessions it seems more likely than not that the market would have further to fall as the economic news gets progressively worse over the next few months.
Against this backdrop, the stock market’s bounce over the last couple of weeks has had a rather eerie quality to it. I don’t think it means much. Large rallies are a fairly common feature of bear markets. I think there are several technical and psychological reasons for a significant rallies to follow rapid falls eg short covering, portfolio rebalancing towards equities and the fear of missing out on a rapid recovery.
I’ve been taking advantage of the bounce to sell more holdings and free up more cash. This week I sold Boohoo, Arcontech, Euronext, Adobe, ServiceNow, Alpha FX, Ansys, Esker and DotDigital. I’m now more than 50% in cash, even without counting the possible injection of funds from my house deposit.
While I think the most likely direction from here is downwards, it could be that the low has already been reached. There is a good chance that lockdowns are alleviated sooner than expected and the long term economic consequences may not turn out to be as bad as I fear. There is simply a huge degree of uncertainty at the moment. It’s very hard to predict what will happen in the actual economy let along how the stock market may react. Given all the uncertainty, I think it’s important to ensure my strategy is prepared for any eventuality and that I don’t get caught out forever holding cash waiting for an apocalyptic crash that never materialises. More on this below.
The performance of my portfolio (QSS) is shown against its benchmarks in the table below. My main benchmarks have been the FTSE 100 and a portfolio of the top decile of UK shares according to their Stockranks. Given the continued out-performance of US stock markets, I’ve also decided to also include the S&P 500 as a tougher benchmark (though note I’ve only started to invest in US equities over the past couple of years). As for the last two yearly reviews, I’ve also continued to benchmark my portfolio against a handful of professional fund managers.
On an absolute basis my performance has been terrible over the past three months. I missed a major opportunity by failing to react more quickly to the Coronavirus. Oh well. On a relative basis my portfolio has held up fairly well against its benchmarks. The only one that has done better over the last quarter has been Fundsmith, with its admirable outperformance backing up Terry Smith’s conviction that his strategy would hold up better through a downturn. That said, I anticipate that the time when Fundsmith will underperform is likely to be not far off now ie during the recovery from the bear market when value typically does better.
One quarter is too short a period to read much into. This review marks a milestone where I have now been following my current quality momentum based strategy for over five years. Over five years I’m very happy to report a 19% CAGR despite the current crash, and that I’m comfortably beating all my benchmarks by some margin.
The main part of my strategy has been to systematically rotate across the quality shares on my watchlist every couple of weeks to take advantage of opportunities as they come up, exploiting changes in momentum, newsflow and valuations. I am pretty confident that this strategy allows me to outperform the stock market on a fairly consistent basis.
However, I’ve long recognised that this strategy provides little protection for overall market crashes. My plan has been to always be fully invested and just ride things out, unless there are exceptional circumstances, where the chances of a future buying opportunity are clearly high enough to warrant raising some cash. For the first time since I started investing, I think we have indeed reached these exceptional circumstances. Even though the market has already fallen significantly, I think at this point the risk of further falls are large enough to warrant holding some cash.
Looking backwards, I should have responded to the risks from Coronavirus sooner, though to be honest I think this may be more of an error in judgment over the severity of the events being played out, rather than an error in the underlying strategy. I’m still minded not to use stop losses in general, but next time the whole market is tanking I might be a bit more cautious in deciding whether raising some cash is warranted.
Looking forwards, I am now in bear market mode. My cash levels are as high as I’m going to let them go and I’m trying to come up with the best plan for reinvesting it. There are two aspects to this: ‘what to buy’ and ‘when to buy it’.
Several aspects of investing get turned on their head in a bear market. While most of the time the market’s main error seems to be to undervalue quality stocks, in a bear market bigger mispricings can arise from overreactions to the risks faced by lower quality businesses. The very best returns can come from investing in businesses which look like they might go belly up but eventually recover. So rather than following momentum, I’m now looking for investments where share prices have fallen harder and valuations look cheaper to take advantage of the eventual rebound. I’m reluctant to stray too much away from my watchlist of shares I have already vetted for quality. There are a few more cyclical businesses within it that have been hit harder that look like they may turn into good opportunities. However, to properly take advantage of a market crash I recognise that I may need to go a little ‘off piste’ and invest in more bombed-out lower quality businesses than I am normally comfortable with. One of my early successes came from investing in bombed out house builders in the wake of the financial crisis. So I am keeping an eye out for this sort of opportunity, especially if the market falls much further from here.
Deciding exactly when to reinvest is also hard. At a high level I have little confidence in my timing beyond a vague notion that there is a good chance the market will fall further before it recovers. Even then I think there is a reasonable chance that I’m wrong and the bottom is already in. Because of this uncertainty I think the best approach is to reinvest steadily and gradually over time rather than trying to pick a bottom and going back in all in one go. So my starting plan is to reinvest at a constant rate every week or so over the next 3-4 months, taking advantage of opportunities as they appear and slowly topping up my existing holdings over time. I might adjust this time period a little depending on what happens (eg I may speed up a little if the market plummets quickly or slow down if the current buoyancy persists) but I think it’s good to start with a rough plan.