Boy… That Escalated Quickly

When investors went to bed on September 20th, 2018, the United States stock markets were at all-time highs and for many the immediate future seemed bright and sunny for domestic stock markets. Those same investors woke up just 95 days later (December 24th) to an S&P 500 stock index that had fallen almost -20% from that all-time high. It’s easy to imagine those poor investors felt a bit like Will Ferrell’s character in Anchorman.

Had the quarter ended at the December 24th low, the fourth quarter of 2018 would have been one of the top 10 worst quarters on record since 1926. Fortunately for investors, the S&P 500 rebounded slightly to finish down “only” approximately -14%1. In dollar terms for a $500,000 portfolio, that would be a loss of around -$70,000 in just a handful of months.

Fortunately, CWM clients as a group only felt a fraction of that overall loss thanks to defensive positioning that has been in place throughout 2018 in CWM investment models. Defensive positioning is wonderful during market selloffs, but it can become imprudent to remain conservatively invested when market valuations are no longer at extremely high levels. Especially after sharp quick market losses occur that often coincide with the rise of irrational investor fear, which can create opportunity for disciplined investors to take advantage of. This article will demonstrate why CWM positioning was defensive prior to the recent selloff, how CWM clients as a whole held up during the fourth quarter market turmoil, what the disciplined response was to these developments, and a look into what the near future might bring.

A Twitter-Worthy Executive Summary

Defensive positioning protected client portfolio values from the sharp market decline in the 4th quarter of 2018. CWM investment models became progressively more exposed to stock assets overtime and current indications suggest we should remain optimistic.

The Time to Be Defensive is Prior to a Market Drop

While all-time high market valuations feel great for investors, there is a strikingly obvious and little paid attention to issue with those high valuation levels. All-time high valuations likely represent that markets are inherently expensive and based on history, the more expensive a market; the more dangerous it becomes. Looking at the graphic below, which depicts market valuations (using the Shiller CAPE ratio) broken into quintiles from the cheapest 20th percentile (low) of historic markets to the most expensive 20th percentile (high) of market valuations. The time periods with the highest quintiles of market valuation have historically also had the worst market drawdowns (average of -18%) while the cheapest quintiles suffer the smallest (-4.5%) in a clear demonstration of why a main CWM investment philosophy is “expensive things are dangerous.”

_{Source: Blumenthal, S. (April 7th, 2017). On My Radar: Valuations, Earnings and Forward Returns. CMGWealth}

Market valuation isn’t the only factor in CWM’s performance targeting system (PTS®), but it does form a significant part of the model’s explanatory power. It also provides a useful demonstration for how the various metrics can indicate the potential of future opportunities/hazards. PTS® uses valuation as one of the factors to help determine when market risks are rising in the attempt to become more defensive prior to periods of significant negative market volatility like everyone just witnessed in the 4th quarter of 2018.

The below forecast intervals are the actual PTS forecasts as of the market close on September 28th, 2018. What this graphic shows is the potential two-year outcome ranges for our proxies for risk (blue, stock positions: S&P 500) and safety (red, bonds: Long-Term Treasuries). These two categories historically are negatively correlated during sharp market sell-offs (i.e. the value of treasuries rise while the S&P 500 falls). The most likely outcomes for either category would be around the forecast points with the statistical high upside or downside potential being the points at either the high or low end of the intervals. What this visualization depicts is that the potential entire range of outcomes for long-term treasuries (safe assets) is in the upper range for the S&P 500. This represents that CWM investment models have a high probability of getting a similar or better outcome to stocks without taking the -19.05% downside risk present for the S&P500. In hindsight, looking at the market drawdown into the December 24th low (just over a -19% loss), that -19% S&P 500 negative forecast was fairly accurate.

_{Source: CWM Analytics.}

The intervals shown above had been fairly constant throughout 2018 and were the primary determinant that led the CWM team to position client portfolios more conservatively due to increased levels of potential downside risk. For example, clients in the CWM Growth model have a normal bias allocation of 80% stocks (risk) and 20% strategic income (safety) assets. Throughout 2018 and until just recently, those percentage were flipped and the Growth model had only 20% in stock and 80% in strategic income assets.

Philosophy and Statistical Modeling < Outcome

Discussing investment philosophy and reasoning based on statistical analysis and modeling is all well and good, but results are what really matters. The table below shows that at the stock market close on December 31st 2018, the S&P 500 value had dropped -13.97% from its closing value on September 28th, 2018 (the last trading day of the third quarter). In comparison, an aggregated average of every CWM Schwab based account was only down -5.10%* for the same timeframe, which is a downside capture rate of just 36.5%. However, no CWM clients are exclusively invested in a 100% U.S. large company stock portfolio like the S&P 500 index represents, so that should not be the only comparison made here. The large majority of CWM clients are in the Growth model, as mentioned in the paragraph above, which has a normal bias portfolio exposure to bonds of at least 20% and the other 80% is diversified in a wide range of both domestic and international stocks. A CWM team favorite simple benchmark for this type of portfolio is the iShares Core Aggressive Allocation exchange traded fund (ticker: AOA), that has a standard allocation similar to the CWM Growth portfolio standard allocation. AOA lost -10.21% in the fourth quarter of 2018 and against this more conservative comparison, CWM clients only captured 49.96% of that downside move. TRANSLATION: CWM client Schwab accounts models lost approximately between 63% to 50% less than relative benchmarks in the 4th quarter of 2018. CWM’s PTS modeling did protect and preserve client account values better than comparable benchmarks in that timeframe.

_{Source: Yahoo! Finance.  Performance calculations use the adjusted closing values, which include the effect of dividend reinvestment. CWM Data Analytics*}

No loss is fun of course, but it is much easier to recover from smaller losses. The green highlighted column in the table above shows the gain needed for each portfolio type to recover from the losses accrued assuming no additional investment contribution is made. The exponential nature of loss recovery (i.e., the bigger the loss; the harder to recover from) is the primary driver of our philosophy “downside protection is more important than upside gain.”

Chaos Creates Opportunity

The great thing about sharply falling market valuations is that those are some of the best environments to take on greater risk exposure (i.e., buy more stocks) with a strong probability of future value growth. Looking into past (see table below), we can see that similar terrible quarters, outside of the early part of the Great Depression (1929 – 1931), set the stage for significant investment returns over the next one to five-year period of time. We are not in a depression, we do not expect to be in a depression any time soon, and we do believe it is time for investors to take on more stock exposure in their portfolios.

_{Source: Carlson, B. (December 23, 2018). Buying When Stocks Are Down Big. A Wealth of Common Sense.}

As markets fell from the end of September to late December, your CWM team followed PTS® disciplines throughout the decline by increasing stock (i.e., risk) exposures in all client model types. Like when moving to more conservative positions, these moves were once again predicated on available market data that shows we have higher probability of success in risk assets. If we again take a look at the PTS® interval chart, this time as of December 24th, 2018 we can see that the ranges flipped from those shown on September 30th (show earlier in this article) with the entire likely two-year performance range of the S&P 500 (blue) completely above even the best possibility for traditionally safer assets like long-term treasuries (red). This suggests that even the worst likely outcome for stocks will be better than the highest likely possibility for treasuries (safe assets). Forecast ranges like this call for aggressive repositioning, which exactly what your CWM team did throughout the decline and around the recent market lows when this below graphic was generated.

CWM PTS® Two-Year Interval Forecast as of 12/24/18.

_{Source: CWM Analytics.}

Clients in the CWM Growth model were 20% stock and 80% strategic income assets on September 30th, 2018 and that ratio has since flipped to roughly 70/30 for that same model type as of the writing of this article. All other client models saw similar increases in stock (risk model) exposures to varying degrees. While this is more aggressive positioning than on September 30th, 2018, client risk models still remain overweight to conservative investments compared to their normal bias allocations (Example: CWM Growth still has 10% more in strategic income than the normal 80/20 normal bias). Any continued move towards more stock exposure will again be predicated on our disciplines and available market data.

So Far So Good

As of January 16th, when this article was written, the markets have recovered well off the late December 2018 market lows (~11%) and first few weeks of 2019 has been one of the best market starts on record. CWM client portfolios have captured more of this upside than they would have had changes not been made to client allocations that increased stock (risk) exposure in the fourth quarter of 2018. Capturing less of the downside market moves and most of the upside is exactly what the CWM team and clients want to see over long timeframes.

_{Source: Yahoo! Finance. Performance calculations use the adjusted closing values, which include the effect of dividend reinvestment. CWM Data Analytics*}

Since the stock market recovery off the December lows has been so sharp, the PTS® interval ranges have come back into more of a normalized overlapping pattern that still suggests stronger upside potential for stocks over the next two-years with relatively the same downside risk potential to safer investments. This means CWM clients should feel confident in current stock positioning and that it also may be prudent to take on further risk-on positioning when warranted. Comparing the below chart to that of December 24th demonstrates how CWM data and modeling captures and adjusts to increasing potential risk, and other factors, as market valuations rise.

_{Source: CWM Analytics.}

Defensive portfolio positioning protected CWM client asset values through the late portion of last year. This preservation of client capital enabled your CWM team to take advantage of opportunities that presented themselves as other less disciplined investors panicked out of their own positions; thereby pushing market prices lower and creating opportunities for the PTS® models to buy on sale and enable clients to benefit from the recent strong market recovery.

Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter.

Morgan Arford
Chief Investment Officer

P.S. Parenting advice in the age of cybersecurity.