What Happens to Index Fund Investments in a Bear Market?

When the market goes down, any investments tied to index funds will follow. Is this a reason to get out of an index fund when you suspect that a correction is around the corner? First of all, the reason you are in an index fund is because you know that the fund will do better than managers who try to time the market. So, unless you have a crystal ball that tells you precisely where to put your money instead of the index fund you are using, stay with it. But, if you had that crystal ball, you would not need the index fund!

Market Watch had a useful piece dealing with this issue. They say there is a test of whether you will win or lose in a bear market with index fund investing.
Their advice is to use a buy and hold strategy with index funds and not to bail out when the market corrects. Rather, use a dollar cost averaging approach and continue to add to your portfolio when shares are cheaper!

Is There Any Use for Active Investments Today?

If you have invested in dividend stocks and are using a dividend reinvestment plan, this is something that you cannot do with an index fund. While the cost of investing with index funds is lower than when you routinely buy and sell stocks or when you use a mutual fund, nothing beats the free reinvestment option offered by a dividend reinvestment plan! If your money is in a stock that has been paying dividends for more than 100 years, this is a difficult approach to beat.

And, it is important when investing to understand how a particular investment is going to keep making money over the years. When you invest in a fund that tracks the S&P 500 you are putting your trust in the American economy. But, if you have unique investment skills and knowhow, you may be able to choose some investments that will replicate the Microsoft story of growing nearly 1,000-fold over the years.

Best Investment Approaches Year in and Year Out

No matter if you choose investments where you will not lose any money but also not gain a lot, or if you go with the passive index fund approach, steady investing year in and year out is more likely to be successful for the vast majority of investors than trying to time the market.

Between the mixed messages on U.S.-China trade and concerns about an economic slowdown, day-to-day stock-picking is becoming very challenging for the average investor, CNBC’s Jim Cramer acknowledged on Tuesday.

“We’ve got to call a spade a spade. This market isn’t just volatile, it’s treacherous,” he said after yet another turbulent trading session on Wall Street. “I don’t want the treachery, which is not going to go away, to get to you. Use it to your advantage.”

The best way for investors to take advantage of the swings is to ignore them altogether, said Cramer, host of “Mad Money.” Instead, he suggested focusing on long-term themes “that hold up through this madness” because they aren’t tied to China or the welfare of the broader economy.

Intrinsic Stock Value

This is the long term investing, value stock approach that uses intrinsic stock value as a guide. As we mentioned in the intrinsic value article, a key to making this approach work is knowing what a company does, how its business plan will make money, and how that business plan will remain viable into the future. In this regard, here are the approaches that Cramer recommends.

Cramer suggests a general approach of picking individual stocks that are not tied to trade with China, are not tied to the welfare of general economy, and have both high dividend yields and strong financial positions. His specific suggestions are cloud-based companies as this sector is growing, health care and pharmaceuticals because people will always need their products and services, and companies in cyber security which seems to be an ever-increasing need.

To his list we might add biotech companies to the degree that you can reliably pick the winners in this arena. And, of course, any company that stands out with more than one of the criteria will be worth a look.

Investments That Will Not Lose Money

What are your other best choices when investing becomes dangerous? Recently we wrote about how to invest without losing any money. We looked at ways to preserve cash in return for foregoing growth opportunities. The four suggestions were these.

• Put money in the bank where it is protected by Federal Deposit Insurance
• Buy US Treasuries, Bonds, Notes, and Bills
• Purchase Investment Grade Bonds, AAA or AA
• Select investments with long term value using intrinsic value as a guide.

Essentially putting all of your assets into cash (bank deposits and government bonds) is a time-honored approach when markets look chancy. Famously, Warren Buffett held a strong cash position going into the dot com crash because he said the market made no sense and thus he was not going to invest until it did!

In Regard to China-Related Investments

China has been the growth story for the last couple of decades. There are investments in China that have done well and investments in companies that do business with China which have also done well. However, all grow stories eventually correct and level off. In today’s China the phenomenal growth story is changing for more reasons that simply getting old or because of the risk of a protected trade war.

Bloomberg has an interesting and useful article about how damage to the Chinese economy from the trade war is already done.

The damage to China’s economy from the trade war with the U.S. can’t be immediately made good even in the case of a resolution with President Donald Trump, Citigroup economists say.
That’s because the tariff war is underlining China’s rising cost of labor at a time when the job market is under pressure, Citi economists led by Liu Li-Gang said in their 2019 economic outlook report. The trade war with the U.S. could cut China’s export growth by almost half next year, putting around 4.4 million jobs at risk, the economists wrote.

“It is a reality that China is losing some of its cost competitiveness, especially in labor-intensive and low-value-added sectors,” according to the report. “Although shifting the supply chains is not feasible in real time, manufacturers may seriously weigh the option of leaving China if punitive tariffs last longer than expected.”

China has become important to the global economy both as a supplier of inexpensive finished products and as a consumer of commodities. A more-expensive China makes products more expensive around the world and will tend to drive supply chains out of China. A substantial reduction in raw material use by China will hurt commodity-dependent economies around the world as we noted in our “resource curse” article some time back.

The bottom line for investors is that China is not the best choice right now for investing by foreigners and especially not by investors who are simply following the herd because the China-investing herd is about to “head south” in a big way.

Likewise, companies that have profited by selling to China, like Boeing, will be hurt in a prolonged trade war.

When Investing Becomes Dangerous What Are Your Best Choices?

All of this is great in theory but how do put these thoughts into practice? Cramer makes several specific suggestions.

Cloud-based businesses he suggests are Salesforce.com, Splunk, VMware and Workday. These stocks will be volatile like the rest in today’s trading but have strong potential for long term growth as computing requires more memory and processing power which will be found in networked computers (the cloud).

His suggestions for health care and pharmaceuticals are United Health Care, Merck, Centene, and Johnson & Johnson.

For cybersecurity he suggests Palo Alto Networks.

In the “strong balance sheet” and “high dividend” niche he suggests AT&T.

If you are going to choose any of these don’t just take Cramer’s advice or ours. Apply the intrinsic value approach to each possible investment along with ways to invest without losing money.

An interesting choice, also mentioned by Cramer, is Microsoft. This company has a strong balance sheet, a huge cloud presence, and is one of the two US companies along with Johnson & Johnson that has bonds with an AAA rating!

When Investing Becomes Dangerous What Are Your Best Choices? PPT

Algorithmic Trading

CNBC writes about machines that control 80% of the US stock market.

“Eighty percent of daily volume in the U.S. is done by machines, so what you get is a lack of focus on earnings, a lack of focus on outlooks and you just get short-term movements based on very specific data that is released every day and that creates noise,” Guy De Blonay, fund manager at Jupiter Asset Management, told CNBC’s “Squawk Box Europe.”

The daily volume of algo trading can change according to volatility. But over the last few years its impact has become more visible. In 2017, J.P. Morgan said that “fundamental discretionary traders” accounted for only 10 percent of trading volume in stocks. This is when traders look at companies’ performance and outlook before deciding whether to buy or sell the shares.

This is the shape of the modern stock-investing world. So, you cannot change it but you can invest in such a way that algorithmic trading does not hurt your investments or even helps them!
Yesterday’s S&P 500 freefall was 782 points out of 27,782. That is a 2.8% decrease in value across the S&P 500. But, going back to 1929 there have been twenty days with larger percentage losses, including October 19, 1987, with a 22.61% loss in the Dow Jones Industrial Average.

Although there were typically good reasons for many of the down days of the Dow or S&P 500, the immediate market movements in recent times often came from computer programs that were designed to sniff out early cues and make trades before the market fell. And, as more programs sold, the other programs followed suit, and in a matter of hours, minutes, and even seconds, the market fell more than the fundamental or intrinsic value of any of these stocks would have predicted.

How does algorithmic trading affect your investments in these cases? It depends on how you react to the market changes.

Using Intrinsic Value as an Investment Guide

On this site we so often write about the use of intrinsic stock value as a guide to long term investing. How does that advice square with the seeming control of the stock market by machines that make 80% of daily trades? First of all, consider what CNBC writes about intrinsic stock value and how Warren Buffett uses it to choose investments.

Buffett’s long-term associate and the Vice-Chairman of Berkshire-Hathaway is Charlie Munger. He discussed how hard it can be to put the intrinsic value approach into practice and how exceedingly selective they are in making their choices.

Munger went on to deflate the hopes of any investor who is confident enough to think they have valuation mastered. When it comes to valuation of companies, even he and Buffett draw a blank most of the time. “We throw almost all decisions into the too hard pile, and we just sift for a few decisions that we can make that are easy. And that’s a comparative process. And if you’re looking for an ability to correctly value all investments at all times, we can’t help you.”

In short, much of the success of Berkshire-Hathaway comes from avoiding the vast majority of investments as “too difficult to call” and directing their attention to those investments where determining future cash flow is easier. This approach has proven successful in their hands and is the “gold standard” for how the intrinsic value approach should work.

Long-term Versus Short-term Investing

If you are going to compete with the trading algorithms that control most of the daily stock trading volume, you need to be very good and insightful or just plain lucky. On the short term basis, these programs are faster than you will ever be. However, they really do follow a herd mentality in both US and global investing. As such, there is always the possibility of picking up bargains the day after the algorithms take the market down. In fact, we often see an up day in the market immediately after a significant market downturn.  But, this approach means that you are always second guessing a bunch of computer trading programs and how they analyze stocks instead of analyzing the stocks yourself.

Buffett and Munger and many others have proven that a patiently-applied intrinsic value approach makes money over the long term.

This certainly looks like, and is, a significant price decline in one day. However, what if we look at the last twelve months?

Now we can see that in the last year the S&P 500 is up about 70 points, after flirting with a much higher range before correcting. But, if we look at picking an investment to hold for five years, as we did recently, here is the S&P 500 going back to December of 2013.

Here we see that the S&P 500 has increased four-fold since five years ago despite a fair amount of up and down volatility. Anyone who was a passive investor and just put his or her money in an ETF that tracked the S&P 500 over this time would have done well and not experienced any pain from fighting the trading algorithms that control Wall Street daily trading. In fact, one could have routinely bought the day after an algorithm-driven downturn and picked up bargains along the way.

How Does Algorithmic Trading Affect Your Investments?

The “bottom line” is that day trading and short-term stock picking are different games than long term value investing. The other “bottom line” is that when investing for the long term is it wise to limit yourself to stocks and other investments where you understand the business plan and where you can be assured that the investment will generate reliable returns year after year. This is why a stock like Coca Cola is always a favorite of investors like Buffett and why many long-investors avoid tech stocks because of the risk of a new invention making a current technology obsolete and reducing a tech all-star to a penny stock in a matter of months.

How Does Algorithmic Trading Affect Your Investments? PPT

As the stock market rally grows older the time will come when the high tech and large cap stocks that are leading will have problems. Then passive investors who simply put money in a fund that tracks the S&P 500 will be in trouble.

Solid fundamental analysis will tell today’s investor to diversify his or her portfolio and look for investments like consumer stocks that will more easily weather the storm of a market meltdown. But if you are a passive investor and you money is in an index fund that tracks the S&P 500 are there too many high tech stocks in the S&P 500 and that will spell trouble when the market turns? CNBC writes that the high concentration of tech stocks is a danger sign.

“The excesses of this bull market are in the glam techs,” Smead said on CNBC’s “Closing Bell,” referring to names like Amazon, Tesla and Netflix.

Currently, 25 percent of the S&P 500 is composed of tech stocks and large cap stocks like Amazon and Netflix. His investment firm, based in Seattle, is the owner of long-duration common stocks.

“It was a danger signal for RCA stock in 1929, the Nifty Fifty stocks in the 1960s, oils in 1981, tech stocks in 1999 and banks in 2005,” he said.

Smead argued that in each era, the large concentration of stock in a particular sector helped propel the bull market, but was followed by a crash made significantly worse because of the losses.

Those who buy into this argument may wish to rebalance their portfolio. Investopedia writes about how to do this.

Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor’s investment strategy or tolerance for risk has changed, she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation.

The asset mix originally created by an investor inevitably changes as a result of differing returns among various securities and asset classes. As a result, the percentage that you’ve allocated to different asset classes will change.

The point of doing this in today’s market is to reduce your risk as the market softens and the risk of a large correction or crash looms. If you want to continue passive investing you may wish to pick another index fund that is not so top-heavy with tech to balance the current S&P 500 or you may wish to pick a handful of consumer, utility or other non-tech stocks as the counterweight to balance your investments. At the current time the problem with holding cash is that the dollar is falling in relation to other currencies and the interest rate is likely to rise which will reduce the value of any bond that you buy.