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Kevin Greenard: Don't catch a falling knife

The investment world has some commonly used sayings, including: “Don’t catch a falling knife.” Essentially this is referring to the danger in trying to purchase stocks as they are declining sharply.
Kevin Greenard

The investment world has some commonly used sayings, including: “Don’t catch a falling knife.” Essentially this is referring to the danger in trying to purchase stocks as they are declining sharply.

Most of the financial articles that write about this discuss that in times of extreme uncertainty and capitulation markets can fall further than one initially anticipates — and this is true.

We often see what is commonly referred to as a “dead cat bounce,” which is a small recovery in the markets followed by further price decline. We have already had a few dead cat bounces.

Timing the bottom

As with every market decline in the past, it is impossible to know when the decline will end. We know the downward descent does end though — it is the timing that is the unknown part.

Another financial saying that is very fitting right now is: “It is time and not timing.” Considerable energy is spent looking at the general direction of the markets and the news to assess when the best entry point may be.

When the stock market has a good day, one doesn’t know if it is the beginning of the next recovery or is it a dead cat bounce.

The right answer is in the middle

When markets are reaching higher levels we will typically raise cash equivalents (10 to 20 per cent), ensure client’s cash flow needs are set aside for at least one to two years, and also temporarily overweight fixed income.

When markets decline sharply then clients do not have to be concerned about selling equities at the wrong point in the equity cycle. In fact, this is the time to reduce the extra fixed income and cash and utilize these funds to purchase the best quality equities.

What we often see with do-it-yourself investors is either freezing and doing nothing with market declines, or jumping all in with the first stage of a correction.

The right answer for us is somewhere in the middle and to give it time.

If the markets have declined to a point where we feel valuations are reasonable given the environment, and long-term view, then investing a portion makes sense (not all at once).

If the markets continue to decline then you can look to invest another portion. The key is to purchase good quality investments — do not speculate.

Every situation is different

We know that the stock market goes through these challenging periods from time to time. Every market correction is a little different. It is in times like these when it is even more important to speak with a portfolio manager.

When we talk with clients, we are always reinforcing the quality of the underlying investments, as most of the companies in our model portfolio have been in existence for over 100 to 250 years. The types of investments you buy and how you react in times of adversity is really the key to the level of long-term success you achieve.

Avoid speculative companies

Over my career I have received thousands of calls about investing in certain speculative names. Most of the companies are small or mid capitalized companies in the mining and energy sectors.

About a year ago, I had over a hundred calls from individuals wanting to invest in bitcoin and cannabis stocks. I’ve also had many phone calls about my thoughts on smaller companies, most of which have no earnings and no ability to withstand a downturn.

I told each individual who phoned that my approach is not to speculate, and that I felt that these stocks were highly speculative. Fast forward a year later and most of the names people were asking me about are down 70 to 90 per cent, while some have already failed. Never purchase a stock based on dividend yield alone, or on the percentage at which it has dropped.

A speculative stock that has no material earnings, growth challenges and is losing money is not an attractive investment, regardless of the yield or percentage it has dropped.

Social media causes more emotional reactions

News spreads so much quicker than it did in decades past. With social media, information is released to the masses.

In addition to social media, nearly everyone has a smartphone or a wearable device to access information almost immediately. On many forms of social media, people have to assess whether the information is even accurate.

Even when I was a child, I remember people saying: “Don’t believe everything you read.” The discussions I have with my kids today is more around them developing critical thinking skills and perspective-taking. What are the motivations and intentions of the individual saying what they are saying?

In the majority of cases, one has to keep events in perspective. Those investors who can methodically think, and focus, on the most likely long-term outcome will be able to deal better with short-term news.

Automated trading

The majority of trades on exchanges now are all automated or triggered by automation. Algorithms or momentum type trading systems have also resulted in increased volatility.

When individuals look at the markets and feel certain price movements do not make sense then it is quite possible that a good portion of the trades were automated.

This is certainly a partial explanation for why the extreme up and down days seem to be magnified.

Mutual funds forced redemptions

One of the reasons pooled funds and mutual fund typically underperform the market in the long run is because of periods like this. One has to remember that unit holders are impacted by all others unit holders who own the fund.

For example, let’s use a mutual fund that has $500 million invested in an equity fund and then the market declines 20 per cent. If the mutual fund declined to $400 million and then it also simultaneously received redemption requests to sell the fund from some of the unit holders, then the fund company may have to sell equities at this lower level in order to fund the redemption requests.

The same would apply if a person had an equity mutual fund and wanted to switch it to the bond mutual fund. When you avoid mutual funds and hold all individual holdings then you can control when an investment is sold, or not sold.

Index investing at peak

In our Nov. 29, 2019, column (Ten reasons to be cautious with Canadian equity ETFs) we expressed our concern about equity exchange traded funds (ETFs). The following is some of the text that was in this article.

Equity ETFS that cover the broad market naturally have a Beta close to one. This means they are equal to the risk of the market.

When the markets are doing well, then ETFs will track that. Using the S&P/TSX 60 Index (XIU) as an example, it has a beta of 1.04 — higher than the S&P/TSX Composite Index. In June 2008, the XIU was $22.81 per share.

In March 2009, the XIU traded as low as 11.41 per share. The XIU essentially dropped 50 per cent. The S&P/TSX Composite Index hit a high of 15,154 in June 2008 and declined to a low of 7,480 in March 2009 — a decline of approximately 51 per cent.

After the markets have had an extended run, we get particularly nervous about ETF style investing. Are you prepared to accept the complete downside of the market if it pulls back quickly?

On Feb. 20, 2020, XIU closed at $27.05. On March 16, XIU closed at $17.95. In less than a month this investment dropped more than 33 per cent.

Index investing after decline

Often at times when the markets have declined sharply and investors want to get invested quickly then an ETF is often the quickest way to get broad coverage. Once the markets do begin to recover then getting selective on the best names is our recommendation.

Knowing your benchmark

Advocates of ETF investing are proud to highlight the returns that equal the market. I have never felt that the end goal of investing is to just own the market and have returns equal to the general market.

Our approach at the beginning of every single year is to beat the market. Beating the market really comes down to not having an equal position in everything. This is especially true when the markets are having a down year.

When markets have hit either extreme lows or highs then it is important to shift from strategic asset allocation to tactical asset allocation. Having a tactical asset allocation when markets are at higher levels can reduce market risk, as compared to a benchmark index.

In many cases this may mean several small tactical decisions, such as, increasing cash slightly, overweighting fixed income slightly, underweighting higher risk equity sectors, overweighting lower risk equity sectors, etc. It is the sum of many smaller decisions that often results in portfolios outperforming benchmark returns, especially after markets have declined.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at Call 250-389-2138.