At the 2022 Investment U Conference in San Diego, attendees all had the same question on their minds.
What the heck is wrong with this market?
In a sense, of course, nothing is wrong with it.
When you have a big spike in food and energy prices, a sharp rise in interest rates, global snags in the supply chain, and a hot war in Europe, you don’t expect investors to blithely bid prices higher.
But it’s the volatility that has even seasoned investors a little unnerved.
One day the market is down big. The next day it’s up big. The day after that it’s down again.
What’s happening is that traders and investors are trying to sort out possible scenarios for 2023.
The bears generally believe that high inflation is here to stay, the supply chain will not come completely unsnarled until later this year and the central bank’s aggressive rate hikes will push us into a recession.
The bulls, on the other hand, believe that inflation is temporary (and may already have peaked), the supply chain is coming unsnarled (with a few exceptions like autos and semiconductors) and we’re on the cusp of a post-pandemic boom rather than an economic contraction.
I tend to believe that the bulls have a better handle on what lies ahead.
But even if they do, that doesn’t mean that stock prices won’t go down further in the short term.
Or… that the market won’t suddenly turn around and start heading north again.
Bull markets begin well before there is an uptick in fundamentals or sentiment.
You need only reflect on the furious rally that started in March 2020 to see that. (The economy had only just gone into lockdown in response to the pandemic.)
However, your primary job as an investor is not to guess whether the bulls or bears are right. It’s to prepare your portfolio for whatever lies ahead, even though you can’t possibly know what that is in advance.
For example, The Oxford Club recommends that you have 10% of your liquid assets in high-grade bonds, 10% in high-yield bonds and 10% in Treasury Inflation-Protected Securities (TIPS).
Keep your maturities short – except with the TIPS – and you will have less interest rate risk and will capture higher yields as they become available.
Conservative equity investors should stick with blue chip stocks like consumer staples, healthcare and utilities.
Moderate-risk investors might focus on sectors like energy, financials and commercial real estate.
More aggressive investors – and those with longer time frames – should look for bargains in beaten-down sectors like technology and retail.
Also, bear in mind that in a down market, large cap stocks tend to hold up best, midcaps next and then small caps. Microcaps tend to get treated like the proverbial redheaded stepchild.
But in the next bull market, the honor roll will almost certainly reverse.
History shows that early in a bull market, microcaps tend to do the best, then small caps, then midcaps and finally large caps.
In other words, if you want to protect your portfolio against more downside, stick to larger companies.
If you want to maximize your upside in the next upturn, concentrate on smaller companies… particularly the ones with growing sales but no earnings yet.
Many of those stocks have been left for dead, even though they’re plenty healthy.
In many cases, they are down 60%… 70%… 80% or more, without missing earnings estimates or issuing one iota of bad news.
When investors go risk-off and stampede toward the exit, it’s the smallest companies that get trampled hardest.
In short, investors should do what I recommended before 2022’s nasty sell-off ever began: Spread their risk both within the market and outside of it.
Your portfolio will hold up better in the downturn that way and you’ll be well positioned to earn handsome profits when things turn around.
As they always do eventually.