This is the time of the year when everyone starts putting out their forecasts for 2017. I've been receiving quite a number of requests for my forecast.
The problem with forecasting is not just that there are too many unknowns... but that people tend to forecast what they want or need rather than what is most likely to result. A forecast is the epitome of a self-induced-confirmation-bias. We filter out that which conflicts with what we need or want and are left with what fits our pre-established picture.
I have to admit that the article title is a little bit of a misnomer... in that I really believe we shouldn't be worrying about WHERE we think the market is headed as much as HOW we plan to reach our own destination.
So, for the time being, bear with me if I DON'T present my forecast as such, but instead, discuss what I perceive as the seminal issues in planning for 2017.
Let me explain...
As most of my followers already know, I'm interested in PORTFOLIO returns, not MARKET returns. What good does it do if the market is down 5% and I manage to outperform by gaining 1%? As a retired investor... 1% return is unacceptable.
A market forecast is just one part of PORTFOLIO planning. Making an accurate forecast is meaningless unless it helps us reach our own goals. It is only the first and possibly the least important step of a five-step process that includes thinking, planning, implementing and adjusting.
So, here's my thinking: I set an investment goal of a 10% return for my 2017 portfolio... my overall portfolio, not just my stocks.
In a typically balanced asset allocation of 60% stocks and 40% bonds/cash with bonds/cash returning, say 2%... the stock (risk) portion would have to return somewhat over 15% to achieve an overall 10% PORTFOLIO return.
Since a 10% balanced portfolio "needs" 15% in stock (risk) returns, should I just forecast a 15% market return, invest 60% in the market through the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), go to the beach and wait? Of course not... that would be silly.
On the other hand, if I'm less optimistic and forecast somewhat lower market return... say 7.5%... my work is cut out for me because I have to outperform the market by 100% to net an overall portfolio return of 10%.
So, do I forecast high?... throw in the towel on moderate returns?... choose riskier investments, riskier asset allocations even leveraging up? ... or figure out a method to make outsized returns in a moderate market without accompanying risk.
That leads to my planning stage: I plan on modest returns for the market... returns in the 5% to 7.5% range. This is not because I forecast or expect modest returns, it's simply what I plan for because it's the Achilles Heel for a balanced portfolio.
If I structure my investments to realize a 10% portfolio return I'll be more than happy to make more if the market has larger gains.
Well, by now many of you are probably rolling their eyes on my plan to make 15% on stock (risk) investments. So, it would be a fair question to ask if this is achievable. The answer is a resounding YES. I point readers to my previous SA article that showed how I intended to deal with 2016. That article was a companion piece to my strategy article which detailed my complete strategy for 2015.
I know many readers are lazy, so I'll present a summary of the 2016 plan.
1) A projected modest market in the 5-7.5% range.
2) Seasonal patterns... up through July, down in August through October and up again November and December (still waiting on December, but it doesn't matter)
3) Reduce risk when market exceeds seasonally adjusted projected performance and increase risk when it pulls back below. A somewhat more sophisticated version of "buy the dip." One REALLY, REALLY needs to read the prior articles to understand this.
4) Use options and other techniques to smooth volatility, hedge downside risk and sacrifice some upside gain to target a 10% portfolio return.
Let's look at my YTD returns...
By examining the graph, one will note that the S&P was much more volatile than my portfolio. I gave up some when the market "ran-away," but patiently waited for the inevitable fall back and "my turn."
As I write this article my portfolio return is just around 8% YTD. If December goes as planned (flat to up 1%) I'll easily hit my 10% portfolio return.
Now, let me bring that into perspective. The market is up 8% and my portfolio is up 8%. What's the big deal? On a normalized 60/40 asset allocation the 8% portfolio returns would equate with over 13% YTD on the stock portion.
I really wish I could discuss, here, in detail, the downside risk... which is limited to about 6% of my portfolio. Even if the market tanks 25% or more, I'm hedged and can't lose more than 6%.
My actual investments are multi-faceted and resultant from many years of development and practice. Not to mention many, many mistake-driven lessons.
Unfortunately SA no longer accepts "stand alone" option strategies, so the best I can do is point you to my scores of articles on SA prior to the SA's current option policy. However, all is not lost as I will be targeting detailed option strategies on Steady Options.
Let me stress that there is no way to achieve exceptional returns without either a) DUMB LUCK, or 2) Attaining expertise or 3) "Borrowing" someone else's expertise.
There is no way to "lend " 40 years of experience but I can "lend" a very simple "add-on" strategy that will illustrate what is possible without too much complexity.
Let me preface it by saying that the SEMINAL THREAT most investors have is in the flat to modest market. Let's say that the market is up 5%. Well, for those with 60/40 mixes the portfolio return is only about 3%. With real inflation close to that, they simply tread water.
Even if stocks are up 7.5% the portfolio return is in the 4.5% to 5% range. Even an average 10% return only provides a portfolio return around 6%... minus real inflation... barely makes it.
So, to combat the chances of a modest return and an unsatisfactory portfolio return, one must look for ways to "juice it up."
First things first: There is no strategy that can be implemented which does not carry some risk. However, risk can be MANAGED... that is... one can choose risk that either 1) loses on a down market or 2) misses the "big move" up. Nothing mind shattering... everyone knows that one gives up some upside if they want to protect against the downside. It's just a matter of what particular strategy they choose.
This is where forecast comes in... deciding what is the more likely scenario and adjusting your risk/return to that market.
For instance, I'm thinking that 2017 could be flat to up 10%. I appreciate that there could be big losses or huge gains. As my prior articles detail, I'm already protected against the down market. If the market is up 10% or more, I'm a happy camper.
But what if the market returns less than 10%? Well, according to plan, I'd be willing to give up the occasional 20-30% market return to assure my 10%. After all, I'm more interested in meeting my goal than getting "bragging rights."
Let's look at how this can be done...
Right know, SPY is trading around $220. That means 10% up from there is $242. I want to find or design a strategy that will return 10% if SPY ends 2017 flat... at its current level of $220. If the portfolio goes up 5%, then the strategy only needs to add an additional 5%, which, when added to my portfolio would equal 10%. Let's say SPY was up 7%, then the strategy only needs to add an extra 3% and if SPY is up 10% the strategy needs to add nothing.
Of course it would be nice if the "add-on" doesn't lose anything if the market busts down. It would be ideal if the strategy provided some gains if the market is mildly down. In short, I know that my portfolio will be down in a down market, I just don't want a strategy that adds to my misery.
That may seem like a pretty tall order... 10% guaranteed return on a flat or up market, coupled with modest gains on a down market to help offset loss on the stock (risk) portfolio.
Well, this can be accomplished very simply provided one is willing to sacrifice market returns in excess of 10%. If you're wildly bullish, you may not want to do this. If you're cautious, you might.
This may not fit your plan, but it is mine.
So, how do I implement this "juice-up strategy"?
Well assuming a $200,000 stock portfolio that mimics SPY...
"Juice It Up" Strategy: Buy a far-dated bull call ratio spread on the SPDR S&P 500 ETF. Sounds "nifty" but it's really pretty simple. Let me break it down.
Start with buying 10 December 15th 2017 call on SPY with a strike of $200. This costs (debits) $27.40 each for a total cost of $27,400. Better to do this than have the money just sit in zero-interest cash.
Now, to offset this $27,000 cost, sell 20 (yes twenty, twice as many) December 15th calls with a strike of $220. Each one credits $13.70 so the TWENTY credits $27,400. The two legs, taken together, have ZERO COST.
Now, here's how they supplement the stock portfolio:
1) If SPY lands exactly at $220 on December 15th 2017, the ten $200 calls are $20 in-the-money, so it will be worth $20,000. The 20 calls that were sold at a strike of $220 expire worthless for a net profit of $20,000. That $20,000 profit represents a 10% return for the $200,000 stock portfolio.
2) For every dollar SPY moves above $220, the long $200 call will INCREASE in value by $1000. Unfortunately, there are twice as many short calls at $220 strike and they will DECREASE in value by $2000. So, for each $1 SPY moves up the option strategy loses $1000. If SPY moves up $6 to $226, the options lose $6000 from the $20,000 initial profit and are now up a net of $14,000.
However, and this is the key... for every incremental decrease on the option strategy as SPY moves upward, there is a proportionate and incremental increase in the stock portfolio of a like amount. So, the total gain of the combined option strategy and the stock portfolio will be a constant $20,000 or 10%.
3) Once SPY reaches $240 (approx. 9%) the option strategy will show incremental losses as the stock portfolio shows proportionate and incremental gains. As a result, any gains in the stock portfolio above $240 are negated and the total gain will always be limited to $20,000.
4) If SPY decreases in value the $20,000 profit at SPY=$220 will start to deteriorate. For each $1 SPY moves downward, the strategy will give back $1,000 of the $20,000. So, if SPY drops $5 to 215, there will still be a $15,000 profit. Interestingly enough, the $5 drop in the Portfolio would represent a $5,000 portfolio loss. When coupled with the, now, $15,000 strategy profit... well, simply put... there is an overall gain of $10,000 or 5% Portfolio gain while the market lost about 2.5%.
But, the more SPY drops, the more of a give back. SPY would have to drop $20 (10%)... to $200... for the strategy to be worthless. But the strategy will never lose anything, regardless of the drop. Of course, the Portfolio, itself, will suffer losses (unless it is further hedged).
This now leads to the adjusting of the strategy. As the year unfolds, if it looks like a break-away to the upside, I can increase risk by rolling the entire program up and capture a greater piece of the upside. Of course, in so doing, if I misjudge and the market breaks back down, I jeopardize making the 10%. If I want to be greedy I have to be vigilant and willing to lose some to make some.
I must add that this particular "add-on" was chosen to provide no downside risk and "juice up" to 10%. One can alter the strikes in almost any fashion to target greater returns with downside exposure or lesser returns with downside help. It is beyond the scope of this article to explore those variables.
Summary: Forecasting the market may be interesting but is of very little real value unless one has a plan that can be implemented to achieve a goal that is meaningful. Everyone's a hero in a wildly up market. It is the stagnant and modest markets that are problematic.
The market presents risk and reward variables that can be managed to fit anyone's outlook. Most investors view risk as the possibility of losing money while attempting to make money. What many fail to realize is that this is only one type of risk. One can manage risk by trading... not loss for gain... rather, by trading potential outsized gain for a high likelihood of reasonable gain.
One way this can be done was illustrated here. A simple ratio bull call spread. I have some downside protection and guarantee 10% return on any upside move. No more, no less.
It is not WHERE we're headed, but HOW we get there that is important.
Conclusion: The most important part of investing is to do some serious thought about the market and then stake out a plan that can be implemented and adjusted to changing circumstances. Simply seeking out a particular market forecast that you agree with is not investing. It is self-validation.
It is of no useful purpose if one correctly predicts the market if the prediction results in an unacceptable result. Better to get the forecast wrong but execute the plan correctly. It's not about being right or wrong it is about managing risk to achieve a particular goal.
Addendum:This article put forth one particular version of the ratio spread. It was designed to fit one particular stated goal. It is not all inclusive and was chosen for its simplicity. There are many variations that can be employed that can skew the strategy to provide more downside protection or more upside potential. There are also more complex strategies that I actually employ and have articles on SA detailing.
I'm most happy and willing to accommodate requests in the comment section. I would ask, though, that messaging not be employed. Not that I don't want to hear from you, it is just the comment section helps educate everyone and avoids my repetition.
Disclosure: I am/we are long SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I buy and sell options on SPY and SPX as indicated in the article.