Warren Buffett, the famous billionaire investor from Omaha, has for decades explained individuals should not invest heavily in the stock market unless they can financially and emotionally withstand a 50% drop in stock prices in their portfolio. Even this top investor saw his company’s Berkshire Hathaway stock price lose 50% in value between early 2008 and early 2009.
Buffett’s top quote and advice to all investors is: “Rule #1 – Never Lose Money, Rule #2 – Never Forget Rule #1”
Buffett understands the power of compound interest and savings. Mathematically, large losses can take many years to regain. A 50% loss requires a subsequent 100% gain just to get back to where you started. Avoiding over-sized losses is critical to wealth accumulation, as small regular gains compound at an astonishing clip when viewed over time.
Considering the challenges facing the U.S. and global economies, we believe the new 5-year highs in the stock market reached on February 19 should be taken with a grain of salt. Massive debt-fueled fiscal stimulus and government spending combined with record interference in “free” market forces by central banks worldwide may convince businesses and consumers the economy can be sustained at present levels.
Plenty could go wrong for investors banking on strong equity returns this year, given the “unlimited money printing” pledges by the Japanese central bank, the European Central Bank and the U.S. Federal Reserve during late 2012 and early 2013. In addition, there are high sovereign deficits and debt levels in many important nations on the planet.
In fact, economic and trade friction between nations may increase the likelihood of major “wars” on the ground in the Middle East and between China and Japan. In a worst case scenario, there could be conflicts among European countries and perhaps between China and the U.S. over time.
We have been accumulating hard assets like energy, real estate and precious metals investments of late to prepare for the effects of unlimited money printing in the real world. You can read the January research report on our gold and silver buys here.
Statistically, our research shows that the American stock market is extremely overvalued. When comparing total U.S. stock market worth vs. yearly economic GDP production, on top of stock prices vs. trailing 5-year earnings, early 2013 ranks in the 96th percentile for “overvaluation” during the last 100 years, according to our own calculations. All other instances, 1929, 1999-2000 and 2006-2007 looked to be great times to sell stocks, and get out of Dodge.
At the same time as January 2013’s near-record equity inflows into mutual funds by mom and pop investors, and ultra-high sentiment readings of 50%-70% bulls in many investor survey, company “insiders” appear to be dumping stocks at an alarming rate.
Based purely on probability analysis, here are the equally-weighted odds we have devised in our work at Quantemonics. With early February as a starting point, the U.S. stock market’s direction could follow one of the following scenarios for the remainder of the year: up 10%, flat, or down 10%, 20%, 30%, 40%. If you take the midpoint of these possible market trajectories, you get a 15% drop from early February–or a 10% decline for the calendar year.
Should you sit in cash the rest of your life because of these fears? Should you be fully 100% invested in stocks and ignore all common sense? We think not.
What can an investor do to prepare for a difficult market span, without selling all stock ownership?
Our goal when we opened Quantemonics Investing was to give small investors an intelligent option to own truly dynamic, diversified and hedged portfolios that can perform well in any market environment, not just a rising bull trend. This area of the financial world seemed to be usually reserved only for the wealthy, but Covestor is today providing such opportunities for investors.
During our first two years on Covestor, we have devised portfolios with little or no correlation to the stock market’s direction. All told, we have been net market neutral to slightly net short in overall design because of abnormally high market risk. This is the main reason the Quantemonics Investing, Relative Value portfolio performance is down 2% (annualized and net of fees) vs. the market’s S&P 500 Index’s 6.4% gain since inception on February 8, 2011.
The flip side is we believe that we are well prepared for a sharply lower stock market and may outline gains for investors in Relative Value (and our second portfolio under development at Covestor.com) on a large market decline.
That’s the advantage of holding a “hedged” portfolio. If you believe, like Warren Buffett, big losses can permanently damage your financial health, methodically designed, hedged portfolios may be something worth looking into for your money, especially at this critical juncture in American history.