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How to Handle Heightened Volatility

North American equity markets are certainly experiencing some interesting times of late. Volatility has picked up and we are now experiencing triple digit intra-day swings in the S&P 500.

Many investors who started investing subsequent to the Financial Crisis have never experienced this level of volatility. If you started investing subsequent to 2009, market conditions in February and March 2018 has probably been an eye opener. If you fall within this group, I would like to share with you a few personal observations on volatility and some recommendations on how to position your investments to take advantage of heightened volatility.

Financial Crisis - Personal Observations

Prior to the Financial Crisis, Coventree Inc. was a major manufacturer of asset based commercial paper (ABCP) in Canada; ABCP was a complex financial instrument which carried the highest commercial paper rating (R1) from Toronto-based credit agency Dominion Bond Rating Service (DBRS). Just prior to the Financial Crisis there was ~CDN $32B of outstanding ABCP.

Coventree was a sizable deposit client of the bank with whom I was employed. It was pulling in billions of dollars of institutional and retail client funds as investors were lured by attractive yields for what were supposed to be short-term investments.

When the Financial Crisis hit, investors learned very quickly that these investments were far riskier than the R1 rating from DBRS. In addition, the highly liquid feature of these instruments turned out to be far different when things turned sour. Read this article to see just how long it took investors to recover their investments!

I also remember other large deposit clients which ‘hit the wall’ very quickly. Bear Stearns and Lehman Brothers were other deposit clients with sizable deposits held with my former employer. Both entities ultimately provided us with 24 hours notice that they urgently needed to repatriate these funds to the United States in their desperate attempt to remain in operation.

In addition, there was a division of Wachovia Corporation which operated in Canada as an asset based lender. For those of you unfamiliar with Wachovia, it was a diversified financial services company based in Charlotte, North Carolina. At one time it was the 4th largest bank holding company in the United States based on total assets. Despite its size, Wachovia was unable to weather the Financial Crisis and it was acquired by Wells Fargo in 2008.

It must have certainly caused considerable angst amongst members of management of Wachovia’s asset based borrowers. Here were financially challenged companies which had to resort to asset based lending and their lender was in dire straits. Fortunately, Wells Fargo stepped in and acquired Wachovia’s asset based lending book of business. In addition, several Wachovia employees jumped ship to my employer and some of their former clients transferred their business to my former employer.

Take Away from Financial Crisis

If we look back at the Financial Crisis, we see that Bear Stearns collapsed in March 2008. The market, however, experienced a rally because many investors thought the worst was over. Six months later, however, Lehman Brothers declared bankruptcy. Six months after that, the markets hit bottom in March 2009.

In hindsight, the bull market started unravelling before most investors realized the magnitude of the unravelling and when the unravelling would end.

I bring this up because I encourage investors to learn from past events.

The Present

In my opinion, we have entered a period of heightened volatility and this is certainly not the time for ‘risk on’ investments.

The following are signs of irrational exuberance which lead me to my opinion.

Marijuana Stocks

Despite a recent pullback, marijuana stocks have been practically unstoppable over the past year. Many of the marijuana companies with market caps in excess of $200 million (these are the larger companies) have doubled or tripled in value.

Many investors have invested in speculative marijuana companies for fear of missing out (FOMO) despite unsustainable valuations. In my opinion, there are several risks with these companies in addition to the fact that most of these companies have yet to generate any meaningful (if any) profits.

Political Risk

While public opinion has been progressive with regard to legalization, the political opinion has not been consistent. In the US, for example, state-level attorneys general have the discretion to bring marijuana charges against people and businesses. This even applies in the 29 states that are currently "legal."

Oversupply Risk

While medical marijuana has been legal in Canada since 2001, the Canadian Federal government introduced legislation in April 2017 to legalize recreational pot by the summer of 2018.

The expectation of imminent legalization has enticed Canadian growers to expand as quickly as possible. Millions of square feet of greenhouse facilities have been constructed or are in some stage of development. If all participants continue with their expansion plans it is entirely possible the market could experience oversupply. If this occurs, prices and profit margins could plunge thus resulting in many industry participants no longer have any realistic opportunity of becoming economically viable.

Dilution of Ownership

Many cannabis-based businesses have little or no access to basic financial services. In some cases they have limited or no access to commercial credit facilities. Some are unable to even open bank accounts in some jurisdictions. Financial institutions that aid marijuana companies could also be criminally charged or slapped with a fine according to a strict interpretation of US federal law.

Marijuana companies are heavily taxed in the US. Profitable marijuana businesses pay an effective income-tax rate of as much as 70% to 90% which leaves very little for capacity or retail expansion and hiring.

Given this, many companies have had to resort to bought-deal offerings (a sale of common stock, debentures, warrants, or options to an investor or investment firm prior to the release of a prospectus or secondary offerings). In some cases, companies have had no issue in raising cash. The issue, however, is that some of this cash has been raised using convertible debentures which can be converted to common stock at a later date. Couple this with options, warrants, and you know that share count is likely to rise in the years to come thus diluting investor ownership.

Bond Yields

Beginning in 2017, the Fed communicated its intent to raise interest rates and reduce its bond portfolio starting in 2018. While these two factors could have been manageable, Congress subsequently passed tax cuts in December 2017 and introduced spending bills. The effect has been to increase the federal budget deficit much faster than most expected. This has forced the US Treasury to sell more bonds, which puts even more upward pressure on bond yields.

We know that higher bond yields make stock dividends a less attractive source of income. At the end of March 2018, for example, the S&P 500 dividend yield was 1.85% and the one-year Treasury yield was 2.08%.

While stocks have capital gains potential and T-bills do not, we must remember the current bull market is roughly 9 nine years old. While it could continue, it is getting long in the tooth and a reversal would generate capital losses and subpar yields.

Investing in equities now means you must accept the unattractive option of accepting lower income in exchange for higher principal risk. Given this, a reduction in the purchase of equities would negatively impact equity prices as would aggressive selling.

Trouble in the Tech Sector

Certain leaders stand out in every bull market. In our recent bull market, these leaders have been a handful of giant technology stocks, Apple (AAPL), Amazon (AMZN), Facebook (FB) and Google’s parent company Alphabet (GOOGL). Each of these companies, however, is having issues.

GOOGL’s ad sales and data collection are receiving some negative attention, as is its near-monopoly position in many markets.

Regulators and lawyers are taking on FB given its success in gathering personal data to use for advertising. This is throwing FB’s whole business model into question.

AAPL’s expensive new iPhone X did not sell as well as expected. In addition, GOOGL Chromebooks are capturing AAPL’s once-dominant position in schools and colleges.

AMZN has recently come into Trump’s crosshairs. In his multiple tweets, he claims AMZN is hurting small retailers and taking unfair advantage of the US Postal Service. Old-fashioned retailers are also fighting back.

While I do not question whether these companies will remain profitable, I strongly suspect their enviable profit margins will be negatively impacted. I am not alone on this front as many investors already suspect this will occur thus resulting in recent stock price declines of these high tech companies. This is problematic for a bull market built on these companies’ once-reliable growth projections.

Crypto Currencies

Investors went crazy for Bitcoin and other crypto currencies. FOMO caused near-panic buying but subsequent to its peak of $19,000 in December, Bitcoin has fallen to ~$7,000. Other crypto currencies have also experienced significant pullbacks.

While many Bitcoin supporters are undeterred and convinced prices will resume their upward trajectory, the immediate effect is that crypto-mania soaked up a lot of uninformed risk capital that is now less able, and perhaps less willing, to take the risk of buying stocks.

According to the Dow Theory, “distribution” is the first phase of a ‘bear’ primary downtrend. In this phase, the last buyers enter the market. These are typically less sophisticated investors and they end up buying investments from larger, more sophisticated sellers who perceive signs of trouble. The distribution phase could already be near its end if these last few buyers have already spent, and often lost, their cash on other, non-equity assets like cryptocurrencies.

Leverage Levels

Investors are more inclined to assume the use of leverage in an effort to increase their investment returns when market conditions are favorable. The opposite is likely to occur when market conditions become unfavorable.

If you look at historical margin statistics reported by the Financial Industry Regulatory Authority (FINRA) you will see a dramatic rise in margin levels in 2017. Now, look at the reduction in overall margin from January 2018 to February 2018! I would be interested to learn to what extent the $20B+ reduction in margin debt was the result of margin calls but I have no idea where to obtain this level of detail.

Given the volatility we experienced in March 2018 I strongly suspect there will be a further reduction in margin debt when the March and April 2018 results are released in May and June 2018. Investors employing the use of leverage are likely to pull in their horns which will likely put further pressure on stock prices.

Recommendations

While another Financial Crisis does not appear to be imminent, I think we will experience:

  • heightened volatility for the foreseeable future;
  • further pullbacks in stock prices.

As a result, I strongly recommend the following:

  • Trim or eliminate speculative positions. There is sufficient uncertainty when investing in high quality companies. There should be no reason to be exposed to unreasonable uncertainty through speculative equity investments;
  • Determine what you want to achieve through equity investing. Once you have done this, write down your short, medium, and long-term goals and objectives. Track your progress but do not spend an inordinate amount of time monitoring the fluctuation of stock prices of your investment holdings (ie. if you are looking at stock prices several times a day…STOP!);
  • Think like a business owner. Equity investing is for the long-term (eg. 10+ years). Money that will be required within the next couple of years should not be invested in equities;
  • Tune out the noise. Watching business related news networks might be entertaining but much of what is covered touches upon short-term irrelevant news;
  • Stock prices will gyrate. Do not try to predict the direction of stock prices;
  • Leverage creates an obligation which must eventually be repaid. The direction of stock prices, however, is uncertain. Do not place yourself in a position where you are creating an obligation which must be satisfied regardless of how your investments perform;
  • Focus on well managed companies with competitive advantages;
  • Learn about a company and its industry before you make an investment and keep apprised of developments of significance. Companies are not merely ticker symbols and stock charts;
  • Seek companies which generate strong free cash flow and which are not heavily leveraged;
  • Dividend income helps you weather ‘storms’. Do not, however, chase dividend yield. If ‘risk free’ interest rates are sub 2%, stocks with high dividend yields should give cause for concern;
  • Companies with a lengthy history of increasing their dividends are great potential investments but excluding companies with a short dividend history is extremely short-sighted. Visa (V), MasterCard (MA), Paychex (PAYX) and Broadridge (BR) are companies which do not have a lengthy dividend track record but they are wonderful companies;
  • Companies can reward shareholders through dividend buybacks, share buybacks, and through the retention of profits. Do not get fixated on being rewarded solely through dividend distributions;
  • Look for companies with low dividend payout ratios. What constitutes a reasonable dividend payout ratio will vary by company and industry. Growth companies, for example, will likely have far lower dividend payout ratios than companies in mature industries (eg. tobacco companies);
  • Spread your investments across most, if not all, of the five main economic sectors (Finance, Utilities, Manufacturing, Resources, and the Consumer sector). The proportions invested in each sector will be dependent upon your objectives and the level of risk you are willing to accept.
  • Create a portfolio which is well diversified but do not ‘throw mud at the wall’. A portfolio of 20 - 35 companies should provide adequate diversification on the condition that many of the companies in your portfolio are not in the same industry/sector.

Recent Investment

In keeping with:

  • the recommendations reflected above;
  • my ongoing strategy of trying to identify great companies in which I am prepared to invest for the long-term;

I continue to analyze companies regardless of the recent heightened volatility.

In most of my recent company analyses, I have come away with the opinion that it would be prudent to wait for a pull back in the company’ stock price. On March 27, 2018, however, I informed subscribers that I would be initiating a position in PAYX after the stock price had pulled back to just under $60 from its high of ~$73 set on January 23, 2018.

Conclusion

While heightened volatility in the equity markets can be cause for consternation, it does not have to be this way. Relish the heightened volatility levels and market pull backs.

When you’re purchasing a house or a vehicle, you’re looking for the best price possible. Think of acquiring shares in companies much the same way.

Hopefully the recommendations provided in this article will be of help and will assist you in taking advantage of heightened volatility.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to charles@financialfreedomisajourney.com

Disclosure: I am long V, MA, BR, and PAYX.

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.

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By |April 4th, 2018|General Investing|Comments Off on How to Handle Heightened Volatility

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