Market declines - what now?

The recent market declines and current increased volatility in share prices have investors ask themselves once again if this may be the time to bail out of the market or if it may be the right time to get into the markets.

Markets have performed very differently on different sides of the Atlantic so far this year.

While the FTSE 100 is down 9% year to date, the German DAX index is already in "correction" territory with a decline ytd of -12.7%.

A generally accepted definition of "correction" is a decline of 10% from the peak and while the larger companies are not quite there (FTSE All share: -9.4%) the FTSE 250 of medium sized companies is down -11.5% and the FTSE AIM All share of fledgling companies has retreated -13% ytd.

Year to date performance of equity indices

The big question is, are these prices buying opportunities or is this correction going to continue and even lead to a fully fledged "bear market", generally defined as a decline of minimum 20% from the peak.

The honest answer, of course, is that nobody knows! My Crystal ball is as good as yours or anybody else's. As always, the case can be made for both sides. There are plenty of risks out there (MP's vote on Brexit, Trade wars, Geopolitical risks) that could easily upset market participants and lead to lower share prices.

Not least an inverting yield curve, where short term interest rates are higher than long term interest rates (eg 2year treasury higher than 5 year treasury, as happened yesterday) are spooking investors, as an inverted yield curve has been going in tandem with economic recessions in the past.

All that being said, this should only be of limited interest to the serious long term investor. We do know that recessions occur frequently and are subsequently followed by economic upswings.

This, according to the last 5000 years of history is as certain as day following night and spring following winter.

Now, to stay with this analogy, if indeed we are in either late summer or autumn of the stock market cycle, then we should expect winter to arrive in the not too distant future (Bear in mind that this year, on 24.October, we still had temperatures of above 20*C and glorious sunshine, so autumns can last longer and fare better than generally expected).

That being the case, taking some profits (reaping the harvest - autumn) and holding a higher than usual portion of cash (the seed for next spring) should be the case for most investors. Please bear in mind that this higher cash position can also stem from dividends paid and not immediately being re-deployed, rather than from actual selling of high quality investments.

Think of your high quality investments as your field: While you may not be able to do much with it in winter and it won't "yield" anything in that time, as a farmer you would not sell your field just because of that, as you KNOW that the next spring will be coming and you need to own your field by the time it comes around.

You will then be able to sow your seeds (cash) that you held back from the last harvest, seen it grow into the next summer.

And while every investors situation is different, in our analogy we all have different size fields, harvests and seeds, the principle is the same for us all: in order to do any farming, you will need to own your land/field in the form of high quality investments as well as some seeds (cash) for when the next spring comes around.

I think it is safe to say that after an unusually long "summer" (> 9 years of markets going up), the autumn/winter is closer than the next spring.

So, do hold more cash (seeds) than during the rest of the cycle, but do not get scared out of the market by selling all your high quality investments (land).

Good land will need the winter to replenish the nutrients in it, so that the seeds can fall on fertile ground the following season.

The same is true for quality companies. The winter (recession) will be used to gain strength in order to better benefit from the next upswing.

Think about it this way:

If you followed the "experts" advise and sold all your investments (land), you either miss out in the next upswing (spring) or you have to buy back the land in good time (probably when every other farmer wants to buy land). You therefore likely pay more for that same land to buy back or, even if you could buy it for the same price or a bit cheaper, you will still have to pay the estate agent (broker) for selling and buying back. Do this every year, and you end up with nothing in the long run. Better to hold on to your land even during times when it yields nothing, but be ready when spring arrives.

I'm aware that this analogy may not work for everybody and its not perfect. However, the message here is clear:

Its late summer/harvest time: Look through your portfolio for any crops that are particularly mature, ie investments whose valuations have become maybe higher than you had expected at the outset and therefore you may want to cut them back a bit, despite them being quality investments.

Hold on to some of your harvest (dividends, profits) in the form of higher cash holdings in your portfolio.

This way, you can sit out the winter, when it comes.

How much is more than usual and how much is right?

Everybody is different, but I believe most farmers will hold enough of their harvest back in seeds to sow their entire field when the time comes.

The main message here is:

Don't fear the bear!

The downturn will come, as sure as winter follows the autumn. But equally, 5000 years of history have shown us that there is always a new spring at the end of winter, be that a short or a long winter.

Hold on to your quality investments even through the "corrections" (on average once/year) and "bear markets" (on average every five years, but we have not had one for over 9 years!!!!), but do hold sufficient cash to benefit from the subsequent upswing.

If you are in it for the long term, this is your best strategy and if in doubt, remember the farmer - he also trusts in the cycle!

RECENT POST