Kathy
in Memos & Musings · 3 min read
Global stocks have tumbled due to fears of a US economic slowdown, sending shockwaves through markets worldwide last week. Japanese stocks experienced their largest-ever daily loss on last Monday, with the Nikkei 225 index in Tokyo closing over 12% lower. This volatility spread to other markets in Asia and Europe, and US stock futures dropped sharply overnight.
Source: The Guardian
Besides concerns about a sharp US economic slowdown and geopolitical tensions, the unwinding of the Yen carry trade also contributed to the market turmoil, heavily impacting the Japanese market. Traders who had been leveraging a previously weak JPY to buy US assets are now facing increased debt payments and forex losses as the JPY strengthens against the USD, triggering a selloff of leveraged positions.
On 5th August 2024, all three market indexes experienced a significant decline, with the S&P 500 and Nasdaq falling by about 2.9%, while our portfolio dropped by roughly half that amount at 1.4%. This demonstrates the usefulness of having a risk-managed strategy.
This was made possible with our Moneyball Investing methodology which part of its feature is to rotate out of certain sectors and to where funds may be flowing to next. We rotated out of tech to consumer defensive companies several weeks back before sector rotation was the buzz word in the financial media.
A recent example was that we bought Adobe in early June but later recycled the proceeds and using cash on the sidelines, to acquire Pepsi and Hershey which we saw possibly better risk-adjusted returns potentially going forth.
While the recent rotation was sudden and aggressive, it makes technical sense with things looking frothy on specific sectors and companies. Elevated valuations although were supported by earnings, there was a lot of speculation on the back of that.
This was covered in our July Market Analysis update for our portfolio subscription service, InvestingNote Portfolio as we shared our concerns with the members.
Screenshot from July’s Market Analysis in InvestingNote Portfolio
Sometime during late June, we also cautioned our members to stay objective and not just simply FOMO into the hyped up AI stocks. Buying with a reasonable amount of margin of safety is important when the pullbacks or corrections eventually happen.
Screenshot from InvestingNote Portfolio’s post
It’s not just about how much you make when the going is good, but how much you lose when the going gets bad. We need days like this to remind us that Mr. Market takes the stairs up but the elevator down. If we can try to lower our paper losses, it often puts us in a stronger position moving forward. We always want to prepare our community like no one else so that we can survive the harshest of the environment.
Take the chance to reflect
To put things in perspective, this minor correction is nowhere near the magnitude of what we had in the 2020 Covid crash or even the more recent one in 2022. If this is painful enough, it only means that you haven’t been conservative enough in your investing approach. And most importantly, use this opportunity to be able to prepare yourself for even bigger crashes in the future by relooking into your portfolio.
Market corrections and crashes are more common than you might think. Avoid the assumption that crashes only occur every 5-10 years and that we can be fully risk-on just because a recent crash happened.
A quick poll conducted across our public Telegram group and on InvestingNote revealed that close to about 40% of respondents experienced drawdowns of more than 10% from Japan’s historic crash on August 5, 2024. And about 70% of the respondents had drawdowns greater than the index.
If we may throw an analogy, investing for market crashes is akin to preparing for earthquakes. This brings to mind our visit to the 921 Earthquake Museum of Taiwan earlier this year. Just as earthquakes are unpredictable and can cause significant damage, market crashes can occur without warning and wreak havoc on portfolios.
Both situations require ongoing preparation to mitigate potential harm. For earthquakes, this means securing homes, having emergency supplies, and creating a safety plan. Similarly, in investing, it involves diversifying portfolios, maintaining a healthy cash reserve, and having a well-thought-out risk management strategy. The goal in both scenarios is to be ready for the unexpected, ensuring that you are not caught off guard when disaster strikes.
We witnessed the remains of the school that once stood at the educational center in the 921 Earthquake of Taiwan
Taiwan’s earthquake preparedness is now among the most advanced in the world.
Similarly to how Taiwan improved its earthquake preparedness following one of the worst earthquakes in its history, we can apply the same principle to market crashes in investing. For instance, just as engineers learn from past earthquakes to design more resilient buildings, investors can learn from market history to create more robust portfolios with better risk-adjusted returns and remain prepared for future challenges.
Decades of learning from disasters, tightening building codes and increasing public awareness may have helped Taiwan to better weather strong quakes.
Learning from past earthquakes helps improve our preparedness, and the same principle applies to market crashes. By studying previous market downturns, we can possibly identify patterns and warning signs that often precede crashes. This knowledge enables us to make informed decisions and adjust our strategies accordingly.
Instead of asking why this correction/crash is happening to my portfolio, ask yourself what are the lessons I can learn from this “unexpected” price decline. If your portfolio faced significant drawdowns on the 5th August correction, ask yourself some of the following things:
- Is your portfolio overly concentrated in a few selected stocks that are highly correlated because they belong to the same sector? This means that your portfolio is not sufficiently diversified to withstand sector-specific shocks.
- Were the stocks you invested in fundamentally sound? When a stock is less fundamentally sound, market participants usually have less conviction in it and tend to pull their money out during times like this. Maybe you can review your portfolio holdings to ensure that the investment thesis is still reasonable.
- Did you buy some of these stocks because you saw how much money everyone else was making? Perhaps your entry into these stocks was driven more by FOMO than by fundamentals, resulting in high entry prices that a correction could easily wipe out.
- Even if your drawdowns are closely aligned with the index, how are you feeling about it? If this is enough to cause you to lose sleep, it might indicate that you are investing more money than you are actually comfortable with.
If we may be presumptuous, one possible likelihood is that your portfolio is heavily concentrated on the US tech sectors, which saw bigger pullbacks than the S&P 500 itself. Over the long term, having a portfolio more heavily concentrated in them may deliver better returns if they can continue to deliver but they do also have their own fair share of challenges and risks that you must be mindful of as well.
Alternatively, we may also try to build our portfolios such that we try to capture much of the upside, in tandem or even better than the benchmark when things are well, and at the same time are able to hold up or lose less during market crashes. Being able to outperform during bull markets is just one part of the story and it is just as important to think about the downside risks as well.
It is important to have an honest conversation with yourself in situations like that. The most important person you need to understand in investing is you. What’s your risk tolerance, and how do you usually react under pressure or when influenced by others? Getting to know yourself is just as important as gaining investing knowledge.
Looking ahead
From where we are now, it is important to have a game plan of what you are going to do next, whether or not we are going to move up higher or even lower from here. From a risk standpoint, it is always good to construct outcomes where either you win less or win more, as opposed to you winning big or losing (even) bigger.
All in all, we would say the repricing of the Mag 7 is very healthy in our view. In particular for the AI-related companies. Some example if we look at the SMH, VanEck Semiconductor ETF, although it’s down by more than 20% from its all time high, it is still up by more than 20% this year.
While the AI thesis and theme is still intact and very alive, we always must learn to manage our downside risks as an investor. Will we rush in to buy aggressively now? Financial YouTubers and the media might be suggesting that yesterday’s crash is just a minor blip and encouraging everyone to buy the dip. While it’s true that in the long term, things often improve, it’s not the time to get overly excited when the S&P 500 hasn’t even corrected 10% from its recent highs.
We need to be very selective about where we deploy our cash. Each investment puts our capital at risk, so we should only invest when the odds are more in our favor. It is better to stay cautious and watch more closely for the US AI-related and tech companies as the downside risks may yet to have fully priced in yet.
Active Trading Tournament 2024 by InvestingNote (Free Participation)
For aspiring traders, the recent market volatility could be an opportunity to put your skills to the test. This year, InvestingNote is partnering with UBS and Societe Generale for this Active Trading Tournament. Participants will be given a sum of virtual capital to invest using real market data and the winner will be determined at the end of 3 weeks. The simulation campaign will start on 12 August 2024.
This tournament focuses on the trading of Daily Leverage Certificates (DLC) which allows both short & long, to facilitate the direction bias of the trader. Due to the compounding effect, DLCs can offer better returns when investors successfully capture a trend. Swing trading strategies, typically lasting from a few days to a couple of weeks, can potentially benefit more from this compounding effect. The reverse is true as well so be very careful although there are airbag mechanisms to reduce the actual exposure of the DLCs to the Underlying Asset in the event of significant adverse price movements.
In addition, for long term investors who need an effective instrument to hedge against short term market downturns, Short DLCs can be a possible solution as well. For example, investors can purchase a 5x Short index DLC to hedge their stock portfolio, assuming a high correlation with the index. With 5x leverage, investors only need to allocate 20% of the capital for this hedging, avoiding the need to sell and repurchase stock holdings, which can incur higher broker commission charges.
For those who are less familiar with DLCs, DLCs stand for Daily Leverage Certificates and are leveraged products with a simple and transparent structure, suitable for various trading strategies and holding periods. Due to their leveraged nature, they are primarily recommended for short-term investment horizons. Note that investors are also subjected to different types of costs and fees when trading with DLCs. If you would like to learn more if DLCs are suitable for you, you may refer to this table below.
Source: Societe Generale
Hence, no matter if you’re bullish or bearish on the market, you can take part in this year’s Tournament where not only can you test out your strategies based on your direction bias and also possibly learn by observing other participants’ portfolios! This trading competition may help to improve your understanding of how DLCs work and if it may be suitable for your future needs.
Get ready for an intense showdown as the trading competition heats up and sign up at this link!
About Kathy
Co-Founder of The Joyful Investors and Manager of The Moneyball Portfolio. I graduated with a degree in Economics in National University of Singapore (NUS). My previous experience with traders at the Merrill Lynch enable me to realize many counter-intuitive truths about how the financial markets work and to uncover the challenges faced by many new investors. We believe that investing can be astoundingly simple and want to make financial education understandable for everyone.
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