To be clear, we are not declaring the current bull market dead. We do not have any illusions of knowing which way the market is headed. However, fortunately, to be successful in investing, we do not need to be able to predict the market direction. Since the average duration of a bear market is much shorter than the average duration of a bull market, our aim should be to thrive in the bull markets and avoid getting hurt in the bear markets.
The current bull market has completed nine years this week and heading into the 10th year. At some point, this will turn into a bear market, just like every bear market is followed by a bull market. As investors, we need to be prepared for the worst, while we hope for the best.
The Volatility Is Back
The stock market volatility has come roaring back since the beginning of February 2018. The markets have been worried over the fact that even though inflation is still low, it has been inching up. The interest rates have been gradually rising and likely to rise even further with Fed announcing its intention to increase rates by a quarter point at least three or four times in 2018. More recently, it has been throwing fits over the possibility of a trade war.
Even though the market indexes recovered nicely after a 10% correction in early February, but in a way, we are not out of the woods yet. It is quite possible that markets may retest the February lows. However, it does not necessarily mean that we are headed towards a bear market. It just means that the volatility is likely to remain high until the market is finally able to shake off its new set of worries. If we were to make a guess, we think the current bull market is not over yet, mainly because the earnings are still growing and there are no recessionary forces in the horizon, at least yet.
Volatility and the Bear Markets
Volatility had been extremely low in the past year until the beginning of February of this year. Many people associate increased volatility to be a sign for an incoming correction or a bear market. However, that is not always true. Last time we had seen volatility this low (as in 2017) in the year 1995. That was followed by very high volatility for the next four years, but the S&P 500 nearly doubled in those four years. That said, higher volatility makes most investors uneasy.
What can we do to alleviate some of these worries about high volatility and a possible bear market?
Keep long-term perspective, even during retirement
Even when you are retired, you still have many years and probably decades available for your investments to grow. As long as you keep 2-3 years of living expenses in short-term investments, you can leave the rest of the money to grow without any considerations of volatility in the market. Obviously, you will need to keep refilling the short-term investment bucket on a yearly basis.
Have a strategy and stick to it
It is important that you have a predetermined strategy going into retirement and stick to it during the times of stress. If we abandon our strategy at the first sign of trouble, it is no strategy at all. Of course, you should select a strategy carefully knowing fully well your tolerance for risk and other goals.
Have confidence in your strategy
Before you plan a strategy, make an honest risk assessment of your situation. Make a portfolio strategy which adjusts and suits your risk profile. This will prove its worth in the times of crisis. If you take more risk than you can tolerate, you will end up bailing out just at the worst time.
Once you have finalized a plan after giving careful consideration to your personal situation, you would need much higher level of confidence in your plan.
Make high volatility your friend
Your strategy should be such that it accommodates for good times, bad times and anything in between. High volatility should not bother you if you have cash reserves for the next two years' expenses and have a sound investment strategy that meets your income goals. An income-oriented strategy will let you sleep well even if your portfolio has dropped 20%, 30% or more. In fact, if you keep some cash reserves, investing at lower prices will do wonders for your future income. For example, the rate-sensitive securities like REITs, BDCs and some CEFs have been on sale recently and offering much higher yields right now than what they were just a few months ago. In fact, this may be the time to add some high yield quality names at a discount, for example, Main Street Capital (MAIN), Realty Income (O), Ventas, Inc. (VTR) and Nuveen Preferred Income (JPC).
How To Construct A Bear Market Resistant Portfolio
We do not know how long the current bull market will last and when the eventual bear market would arrive. Since the markets are always uncertain, we should devise a portfolio strategy which can survive the bear markets well enough and thrive in the bull markets. Below we will provide a portfolio strategy that will do just that.
As in our past articles, we emphasize the importance of dividing your portfolio into three or four buckets. For retirees, especially the ones who need income, it is important that majority of their strategies are income centric in one way or the other. An income centric strategy will make it a lot easier to ride out any financial storm.
Bucket-1: DGI Portfolio (40% of the overall portfolio)
Retirees need income and safety of principal more than the capital gains. To meet these objectives, what can be better than a bucket of investment in solid, blue-chip, shareholder-friendly, relatively large companies that have a history of paying and growing their dividends. Sure, their market prices will move with the broader market and likely to go down if the broader market takes a hit. However, such companies will resist the downward pressures better than the rest of the market. Moreover, the income generated from their dividends will help ride a bear market without selling the shares at the worst time. Our average income targets from this conservative bucket should be 3-3.5% based on the starting yield.
For a selection of such companies, the most important criteria should be their ability to sustain and possibly grow their dividends. We present one such portfolio of 20 companies.
List of securities: T, VZ, MA, MCY, CVX, VLO, MO, UL, PG, OTCPK:NSRGY, PEP, LMT, AAPL, MSFT, CVS, PFE, AMGN, JNJ, D, WM.
Bucket-2: High Income Portfolio (30% of the overall portfolio)
Every retiree should preferably have a basket that has 10-15 high-yield securities. Here are some likely questions that normally come up:
Will such a bucket be riskier?
Sure, the risks will be slightly higher. But the main advantage would be to draw a major portion of the income from this portfolio. This will reduce the need for other baskets to take on any unnecessary risks. With the high-yield portfolio, the main advantage comes from the fact that during bear markets, even when the portfolio's market value may be going down, but the income is not. That would make it easier to ride out any storm.
Also, some studies show that it is possible for a high-yield portfolio with almost no growth to grow the income faster or similar to a portfolio with low yield but higher growth. SA Author Steven Bavaria had published an interesting article here to prove this point.
How much allocation should be made to this bucket?
We believe one size does not fit all. The answer to this question will depend on many factors, like the investor risk profile, size of the overall portfolio, and the amount of income needed from the total investment portfolio.
Types of High-Income Portfolios
In our book, any portfolio that can provide 6-8% or more on a consistent basis, we would call it a high-income portfolio.
We can think of two such portfolios. One can choose one or both depending on the time and expertise of the investor.
High-Income Portfolio-1: Using REITs, BDCs, and CEFs
Security Type | Symbol | Name | Yield (03/07/2018) |
BDCs/mREIT | |||
Ares Capital Corporation | 9.56% | ||
MAIN | Main Street Capital Corporation | 6.23% | |
Annaly Capital Management | 11.68% | ||
Golub Capital BDC | 7.08% | ||
NRZ | New Residential Investment | 12.09% | |
REIT | |||
Realty Income Corp | 5.17% | ||
Omega Healthcare Investors | 9.64% | ||
STAG Industrial | 5.97% | ||
STORE Capital Corporation | 5.06% | ||
Ventas, Inc. | 6.17% | ||
CEFs | |||
Cohen & Steers Tot Ret Realty | 8.01% | ||
Cohen & Steers Infrastructure | 8.68% | ||
Nuveen Muni High Inc Opp | 5.61% | ||
Kayne Anderson MLP | 10.45% | ||
Tekla Healthcare Investors | 8.46% | ||
PCI | PIMCO Dynamic Credit Income | 8.68% | |
JPC | Nuveen Pref & Income Fund | 7.93% | |
Columbia Seligman Premium Tech | 8.05% | ||
| TOTAL/ AVERAGE | 8.03% |
High-Income Portfolio-2: Using Options Selling
This type of portfolio for generating income assumes that the investor is comfortable with selling PUT and CALL options. The goal should be to be able to generate 10% income on a yearly basis.
Selling PUT Option:
- We only recommend selling cash-covered PUT options, so that if a stock gets put to you, you have the CASH reserved to buy the stock. Selling naked PUT options on margin is NOT suitable for most investors.
- Sell PUT options on stocks that you do not mind owning, at least for six months to a year. For this reason, always sell PUT options on dividend-paying stocks. A dividend-paying stock would make it easy to hold and ride out any downturn.
- Sell PUT options only on blue-chip, relatively large, dividend-paying, cash-rich companies. Sure, you will not get huge option premiums for such companies. However, if we are able to get 10-15% option-premium, we should be content. Anything more than that would indicate that either the current market environment is highly volatile or the stock is too speculative.
- Strike-price: Choose a strike price that is 3-5% below the current price (depending on the stock's monthly volatility) and provides 10-15% option premium.
- Time to Expiration: If you are doing it for income on a repeatable basis, one month out expiration is appropriate. Less than that will require too much trading and more will not generate enough income.
Example:
Let's assume we do not mind to own AT&T stock since it is a stable company with over 5.46% dividend yield at current prices. We sell one PUT option contract as below:
Sell one cash-covered PUT option contract
Underlying stock : | AT&T |
Present price: | $36.65 |
Strike-price: | $35 |
Expiration date: | April 20, 2018. |
Option Premium: | $52 |
- Strike-price is 4.5% below the current price. Expiration is 42 days away.
- If the price stays above $35, the option will expire worthless and $52 premium over 42 days will equate to an annualized return of 12.3%.
- If the price falls below $35, the stock will be PUT to us, meaning we will be required to buy 100 shares at $35 a share. However, after counting $52 of premium, the cost basis will be $34.48. We will own the stock and earn 5.79% dividend yield (on our cost). We can then turn around and sell a CALL option if we like.
Selling CALL Option:
- You can generally sell a Call option on a stock that you already hold in your account.
- You must have 100 shares of a security to be able to sell one contract.
- The strike price should be above or near your cost basis. If the current price is a lot below your cost basis, there are two options. First, you could wait until the market price comes back close to your cost basis. If the stock pays a reasonable dividend, we would not need to sell in distress.
- Or as a second option, you should look at the volatility related to the underlying stock over say one month. For example, let's say the monthly volatility is 3%, you could sell one month out Call option with a strike price at least > 1.03 * current price.
- Pay attention to the date of next dividend. If the next dividend record date falls before the expiration date, the strike price should be well above the current price. Otherwise, the call buyer will exercise the option just to capture the dividend.
- The option premium plus the dividend accrued during the option period should preferably be 10-15% (on an annual basis).
Example:
Let's assume we own 100 shares of AT&T, and we sell one contract as below:
Sell one CALL option contract
Underlying stock: | AT&T |
Present price: | $36.65 |
Strike-price: | $38 |
Expiration date: | April 20, 2018. |
Option Premium: | $38 |
Next Dividend Record date | April 10, 2018 |
- The strike price is at least 3% above for a low volatility stock. The expiration is about one month; in this case, 42 days.
- If the stock price remains below $38, the option will expire worthless, and we will keep the premium providing us an annualized return of 9.01%.
- AT&T will also pay $0.50 a share dividend in the meanwhile on April 10th, so if you were to include the dividend, our return would be a total of $88 ($50+$38), or 20% annualized return.
- If the price moves above $38 and the option is exercised, we will earn a total of $178 ($38 premium plus a capital gain of $135 based on today's price).
Bucket-3: Risk-Hedged or Risk-Adjusted Bucket (30% of the Overall portfolio)
The main purpose of this bucket is to lower the volatility and the drawdown of the overall portfolio during the times of stress. If the overall market goes down 50%, this bucket should go down no more than 15-20%, thus bringing down the drawdown of the total portfolio. There are strategies that do just that. At least they have proven to be very effective in achieving the above goals in the past; nevertheless, they may not behave in the exact same manner in the future.
Another advantage of having this bucket is to provide diversification of strategies. We very well know that when one strategy zigs, some other one may zag.
We will list one such Risk-Adjusted strategy here.
Sector Rotation Strategy
In this strategy, our universe of securities will be 10 sector-based SPDR ETFs and one mid-term Treasury fund. Every month, we will be invested in the best performing (and trending) sectors. For example, currently, the Technology and Consumer Discretionary sectors are doing better than the rest. So, basically, we are advocating that instead of investing in the entire market like the S&P 500 index fund, we invest in this strategy, where we capture almost all of the upside of S&P 500, but we stay out of the market during the times of stress. When we are not invested in the market, we either invest in long-term Treasury fund (TLT), or mid-term Treasury fund (IEF) or remain in Cash. An investor who may be of the opinion that Treasuries are not going to save the day in a future crash could use the short-duration Treasury fund (SHY).
As far as income is concerned, the dividend yield will be similar to the S&P 500 (generally around 2% most times), but we assume that rest 2-3% could come from withdrawals for investors who depend on this income.
The main advantages of this strategy are:
We will be invested in the best performing two sectors of the economy at any time rather than invested in all 10 sectors. If none of the sectors are performing better than the risk-free assets, then we will be invested in mid-term Treasuries and/or cash. By using the risk-adjusted approach, we are able to reduce the drawdowns by less than half of the broader market. As an example, during 2008 crisis, this strategy would have had a drawdown of -17% versus -50% for the S&P 500. The return from this strategy during the year 2008 was +5% versus -37% for the S&P 500.
Though the strategy can have so many variations, the back-testing results from one such strategy are provided below. The look-back period for measuring performance is three months with monthly rotation.
Conclusion
We have presented some of our favorite ideas and strategies. We do not believe in investing all of the capital in just one strategy. For example, we believe a DGI strategy will be very good for anyone but often falls short on income. Also, during a bear market, it will fall along with the market, albeit a little less so. To increase the income to a decent clip, we add a high-income strategy. To contain the overall risk to the portfolio from a bear market, we mix a rotation-based risk-adjusted strategy. Also, this combination of strategies provides diversification benefits. For example, our high-income bucket, as presented above, has a correlation of only 0.57 with the S&P 500, which will help reduce the overall risk of the portfolio.
Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolio presented here is a model portfolio for demonstration purposes; however, the author holds many of the same stocks in his personal portfolio.
Author's Note: Portfolios such as 8% Income CEF portfolio, 6% Income Risk-Adjusted portfolio, 401K-IRA-Conservative portfolio, Sector-Rotation ETF portfolio, and High-Growth BTF portfolio are part of our SA Marketplace service High Income DIY Portfolios. For more details or a two-week free trial, please see the top of the article just below our logo.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
