Most of the investing world hailed the current bull market taking over the crown as the “longest bull in history” on Aug. 22. While there were a few dissenters arguing over that distinction, by most measures, the current bull market began on March 9, 2009, putting us well into its ninth year and now surpassing the length of the 1990s bull market.
There probably are better measures of a bull market’s vulnerability than simply the number of days since the last bear market ended. We prefer to measure market valuation and assess whether a catalyst is in place that’s creating the conditions for its eventual end. And judging by all those indicators, the current bull market looks old, overvalued, and potentially ready to roll over into a bear market. That doesn’t mean it will do so imminently, just that the necessary conditions of why it could are in place.
Why investors won’t walk away
So why don’t investors recognize when a bull market is over-extended and walk away? It’s not an information issue, as the market’s record bull length, its historically high valuations, and the “catalyst” of Federal Reserve actions have all been well chronicled.
No, the reason people stay invested as risk rises late in bull-market cycles is because that’s when the stock market tends to deliver some of its best returns! Look no further than the recent performance of SMI’s most aggressive strategies. As we noted last month, over the 12 months ended June 30, Stock Upgrading was up +15.2% while Sector Rotation soared a ridiculous +46.5%!
It’s hard to walk away from that type of potential upside, especially when it’s a well-documented fact that valuation is a poor timing indicator. The past few years have reinforced what investors also saw in the late 1990s: high returns can continue long after the market’s valuation indicators start flashing warning signs.
SMI’s approach to aged bull markets
Trying to predict when bull markets will end doesn’t work. So what can investors do instead? Here’s SMI’s approach to dealing with late-cycle bull markets:
This assumes you’re using an appropriate blend of SMI’s strategies, some of which have defensive properties that we believe will help reduce (not eliminate) the impact of a future bear market.
Have Reasonable Expectations
This applies both to your overall portfolio, as well as each individual component. We know that by continuing to invest late-cycle, we’re almost guaranteed to give back a portion of our late gains when the market finally shifts from bull to bear. Hopefully, you’ve made peace with that idea so it won’t be upsetting when it eventually occurs. The defensive properties of the SMI strategies are intentionally designed to kick in slowly, ideally triggering only occasionally, during particularly damaging conditions.
There’s always a trade-off with defensive efforts: either the protocols trigger quickly, causing us to endure numerous false alarms that cost money and frustrate everyone along the way, or they trigger slowly and infrequently, which requires us to absorb some degree of pain at the end of the bull market cycle. This happens as our fully-invested portfolios work their way down from the prior highs to the levels where the defensive protocols kick in and start getting us out of stocks.
Regarding the individual strategies, understand what each is expected to do. Upgrading, and especially Sector Rotation, are supposed to perform great in the current environment. Dynamic Asset Allocation isn’t. It’s supposed to do okay now, but be great in the opposite environment — bear markets. Over full market cycles and the long-term, DAA’s historical performance has been better than the overall market. But it gets there by outperforming during bear markets despite lagging the market at the end of bulls.
Play Good Defense
Before discounting DAA too quickly in the current environment, consider the vital role it plays in incrementally playing defense within a portfolio. Psychologically, it’s tough to make significant changes to one’s stock allocation all at once. That’s one reason why traditional market-timing approaches don’t work for most people: apart from it being extremely difficult to figure out accurate signals, those trades are emotionally brutal to execute.
Contrast that with DAA, which never has more than two-thirds of its holdings in stocks at any given time. DAA recently sold its foreign stock holdings after owning them roughly a year and a half. That wasn’t a particularly hard move for SMI members to make: it was only a portion of the portfolio and DAA makes similar changes fairly regularly. While it likely didn’t feel like a “big deal” to readers, the result was to lower DAA’s stock allocation to just a third of the portfolio.
Who has the easier emotional path from here, if the market declines and it becomes clear we’re in the early stages of a bear market? The DAA investor who simply has one more incremental step of eliminating a one-third position in U.S. stocks at a pre-established interval, or an investor who has been heavily invested in stocks for years and has to figure out when and how much to trim that heavy stock allocation?
Another key development in our ability to play good defense was the introduction of Upgrading 2.0 at the beginning of 2018. While the research indicates we shouldn’t expect Upgrading’s bear-market defense to be quite as strong as DAA’s, it does allow us to confidently keep Upgrading money invested right through the end of a bull market, while still expecting some reduction to the losses inflicted by the ensuing bear market.
SMI members using the type of multi-strategy approach we frequently discuss likely have a good portion of their portfolios covered by some type of defensive protocol. For example, a 50/40/10 portfolio would have 90% of the portfolio covered by either DAA’s or Upgrading 2.0’s defensive measures. Those actions are built right into the strategies themselves, so members don’t have to do anything special. They just keep following the monthly instructions as they normally would. This should help tremendously with actually executing the defensive steps, because those steps won’t feel particularly unusual or like they’re coming from outside the normal system.
The bottom line is that SMI’s strategies allow us to stay invested through what can be surprisingly long “late” bull market periods — harvesting those gains — while still seeing our downside reduced when bear markets hit. Long-term, we think that approach will lead to better results than trying to anticipate bear markets and reduce stock exposure beforehand. Mentally and emotionally, it’s much easier to follow the same strategies long-term: through bull markets, bear markets, and those confusing periods when we’re not sure which animal is in charge!