3 Moves to Make in the Current Market (+ 1 Tip from Cathie Wood)
It’s been a rocky few weeks in the stock market, with many worrying news about high inflation and the new Covid-19 variant Omicron (not the crypto). As an active investor, I thought deep about my next move and referenced renowned investors. Here is my current market analysis and 3 moves I will take.
Rising Inflation — Cash Loses Value
First, where are we today in the market? I highlight 2 key trends that I believe are paramount for investors.
The purchasing power of the dollar over the past 76 years has declined by 94%. Meb Faber shows in his book Global Asset Allocation that what used to be a $1 can only get us 6 cents today.
This is the effect of typical inflation which was 3.3% on average (nothing to do with QE yet based on this timeframe). Hence we always hear how important it is to INVEST instead of leaving cash in the bank. By taking a bit more risk, we can better maintain the value of our hard-earned money.
Covid-19 drastically changed the history of money with the massive money supply that inundated the economy in 2020. This further devalues cash. Look at that vertical line, it’s mind-blowing.
How long will this continue without consequences? Already, the US reported its highest inflation jump to 6.2% since the 1990s.
Overvalued Stock Market — Risk in Equities
Although I believe in buy-and-hold over the long-term, valuations do matter. The price you pay influences your rate of return. Pay a below average price and you can reasonably expect an above average return, and vice versa.
Ten-year CAPE Ratio vs. Future Returns, 1900–2014, Meb Faber
Future returns are dependent on the starting valuations. CAPE Ratio, or the Cyclically Adjusted PE Ratio, is the PE ratio based on average inflation-adjusted earnings from the previous 10 years.
Faber’s research shows that beyond CAPE of 25, median future real returns are 1–2%. Once CAPE ratios rise above 30, forecasted returns can be negative for the following ten years. Guess where we are today? Yes it’s the red dot.
Tricky Dilemma
Both of these trends present a tricky dilemma — the value of cash is being eroded at the fastest pace in history, and the traditional markets are overvalued.
Historically, stocks and bonds perform the best when inflation is below 3%. Once inflation goes above 5%, returns fall drastically.
Source: Global Asset Allocation, Meb Faber
Taking a leaf from renowned investors’ playbook, what are some possible strategies?
1. Consider investing in real assets i.e. commodities, gold, real estate (including REITs)
As a millennial born in the 90s, I was too young when the 2008 meltdown happened for it to mean something to me. For many of us, we have only known the incredible bull market in equities for the past decade. Hence generally, we are extremely overweight in growth equities and underweight in ‘traditional assets’ like bonds or real assets.
I hereby think there is merit to look beyond the comfort zone and consider real assets.
From a comprehensive analysis of 13 different asset allocation strategies, Faber found those that performed the best in the inflationary 1970s are those with a higher percentage of real assets. Namely: Permanent (25%), Marc Faber (50%), El-Erian (32%)
Marc Faber’s Allocation
Note, the Buffett strategy that was studied is made of 90% stocks 10% bonds. Not surprisingly, with a lack of real assets, it performed the worst during the inflationary 1970s (other than pure stocks).
2. Reduce allocation to high-growth equities
Correspondingly, I will slow down my allocation to growth equities like Tesla and Unity. Unless a correction of >10% occurs, in which I will add 0.5% of my portfolio.
3. Invest in “cash-like innovation stocks”
This is a very interesting insight I caught from a CNBC article on Cathie Wood.
The fund is not allowed to hold any cash, so instead the dollars are parked in what Wood called “cash-like innovation stocks,” which includes Apple.
The FAANGs certainly meet that criteria — they’re acting like defensives,” she said. “During a period of volatility like we’ve just seen, we will sell those stocks and move into either our more pure-play or earlier-stage innovation companies that are being hurt by risk-off.”
Basically, this is an alternative or concurrent way to point 1 (buying real assets). Since it is futile to time the market, rather than sitting on the side with cash that is eroding in value, the strategy is to rotate into defensive tech stocks. Examples include FAANG.
When the crash comes, they will drop relatively less than other equities → sell them to buy back into the high-growth stocks like Tesla, Fiverr etc.
If the crash never comes, they will appreciate steadily and still beat inflation.
What will I do?
I will do a combination of all 3:
- Reduce purchases of high-growth equities and sell some clearly overvalued ones (as I did for Unity)
- Put cash into REITs, Microsoft and Amazon (since I already own them)
- Continue DCA whenever there is slight correction
While it may seem like I am predicting a market crash, I am not. I’m merely being cognizant of “where we are today” as Howard Marks said and adjusting my next steps.
Just like how we decide what to wear based on the weather today, I will not stop venturing out and enjoying life.
