Sunday, 9 October 2016

How Should I Defend Against the Next Market Crash?

Barely 2 weeks after I wrote The Exit Might Be Narrower Than Expected, both British Pound (GBP) and Gold demonstrated what I have been worrying about. In a space of 1 week, GBP dropped by 3.8% while Gold dropped by 4.4%. GBP dropped after the British Prime Minister announced a timeline for starting Brexit talks with the European Union while Gold dropped on renewed fears of US Federal Reserve raising interest rates on the back of an improving economy. In particular, on Fri, GBP dropped 6.1% within 2 minutes. The sudden drop was rumoured to be caused by a fat finger (i.e. trading error) or computer trading algorithms. Regardless of the actual cause, the fact that the forex markets could not even defend against a fat finger speaks volume about the lack of depth of the financial markets against massive selling volume. It is definitely something that I need to guard against for my own portfolio.

My target asset allocation in the current investing environment is 50% equities and 50% reserves. Although I am wary of the financial markets, I do not believe in holding 100% reserves. During the market turmoil in Jan, I calculated that I need about 35% reserves to guard against a major stock market crash (see Prudence is the Name of the Game). A target allocation of 50%, which is 15% above the minimum required, is considered comfortable and not excessive. Too much cash would lead to erosion of value due to inflation while too little cash would lead to inability to recover from the crash. A rule of thumb that I always use in place of a detailed Value-at-Risk analysis for equities is a loss of 40% at the depth of the crash. Naturally, the loss depends on how severe the crash is and what are the stocks held. During the Global Financial Crisis in 2008/09, the loss was as high as 65%.

Thus, the problem statement becomes how do I invest the 50% in equities such that they will not suffer too much damage and how do I park the other 50% in other assets such that they can preserve their value.


Looking at my current stockholdings, the elephant in the room is Global Logistic Properties (GLP), which has a concentration of approximately 19%. The stock is a transformational experiment in trying to replicate the success of Warren Buffett. To achieve this, I need to be able to do 3 things: (1) identify a good stock, (2) concentrate, and (3) hold for the long term. Therefore, even if a crash is coming soon, I will not sell out of GLP, unless its business fundamentals deteriorate. Selling out entirely would mean that I cannot achieve at least 2 of the 3 pre-requisites required to replicate his success. Notwithstanding the above, I am happy to reduce the concentration to 15% if the price recovers to my cost price.

The second group of stocks is Oil and Gas (O&G). They are mired in heavy losses currently, but the advantage of this group of stocks is that they have their own dynamics and are less affected by global events. If OPEC were to cut production significantly, it does not quite matter to O&G stocks who wins the US presidential election or when Brexit happens. Over the past 5 months, I have mapped out a model to assess the economics of O&G companies in a series of Oil & Gas posts and will follow the plan accordingly.

The third group of stocks is growth stocks. As their moniker suggests, they grow their earnings over the years. Growth stocks can rise a lot during good times as investors chase after them, making them especially vulnerable to a market crash. However, given their ability to grow over the years, their share prices after the crash should be higher than before the crash.

The fourth group of stocks is dividend stocks. There are 2 types of dividend stocks, namely, those which have a constant payout ratio but the dividend varies with earnings, and those which have a constant dividend. My preference is for the second type of dividend stocks. They resemble closest to bonds that have constant coupons, which give bonds the ability to drop less than stocks, as described in What Can We Learn About Stocks From Bonds. If a stock could give me a constant 5% yield on my historical cost every year, I really would not mind if the stock were to drop 50% in a crash.

A small group of stocks that is worth mentioning is the nothing-to-lose stocks. They are considered nothing-to-lose because the amount invested in them is very small, making them easily written off the moment they are purchased. A brief explanation of them can be found in My Oil & Gas Fightback. Since there is already "nothing to lose" on them, it really does not matter if they were to crash 50% or more.


Most of the time, I only need to worry about the risks on the equities portion. This time round, I have to worry about the reserves portion as well due to the extremely low interest rates currently.

Traditionally, the main instrument for parking excess cash is bank preference shares and retail bonds of good companies. However, ever since the redemption of OCBC's 4.2% preference shares in Dec 2015 and the surprise loss of liquidity in retail bonds in Aug 2015 as described in Sneak Attack on My Cash Reservoirs, this instrument has reduced in importance.

Thankfully, around the same time as retail bonds demonstrated hidden liquidity risks, a new instrument was introduced -- the Singapore Savings Bonds. It has 2 important benefits, namely, easy liquidity and 100% capital protection, making it ideal to preserve value and liquidate for stock investments at the depth of a market crash. The disadvantage is that there is a limit on the amount that can be invested.

The other instrument that I have used to park cash this time round is US dollar. Given the impending rise in US interest rates, USD will also rise in tandem as explained in Getting Ready for US Interest Rate Rises. However, there is a limit on the amount of cash that can be parked in USD, as there is not a lot of USD-denominated assets that can be purchased. My preference is not to switch in and out of USD so as not to incur the bid-ask spread.

All other instruments have more disadvantages than advantages. Singapore Government Securities (i.e. government bonds) will fall in value when interest rate rises. Likewise, Gold will drop when USD rises, as demonstrated this week. There is really not many places to park cash safely.


In my opinion, the current investing environment is tricky. But there are also not many places to hide safely.

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