Managing a Drawdown

I have been mostly on the right side in calling the stock market’s short term movements over my investing lifetime. Although accurately predicting the market’s short term gyrations is much more difficult than forecasting where the stock market will be in 5 years, I believe it is feasible with well-reasoned analysis which incorporates market sentiment, technical analysis, stock market history, macroeconomic fundamentals, valuation, and the simple view that markets are inherently cyclical.

After correctly predicting “a 5-15% multi-month correction to refresh the bull market” near the all-time high last year, I believed that the market’s ensuing selloff in the second half of 2015 was sufficient for washing out excessive optimism and reseting valuations. Thus, I did not see nor position my portfolio to withstand the market’s 10% drop year-to-date. In retrospect, I underestimated the impact that the Federal Reserve’s first rate hike in nine years would have on the market. It is now clear that the market needs more time to digest it and the relentless selling is to ensure that the pace of interest rate rises that the Fed is planning is slowed.

By being 90% invested in equities, with a heavy weighting in financials, my portfolio has suffered a meaningful 15% drawdown in 6 weeks. However, this is not my first experience dealing with losses. I have found that it is important to re-evaluate your original investment thesis, while giving close scrutiny to the arguments that are being put forth for justifying why your positions are going against you. If you determine that your initial analysis was faulty or did not incorporate important information, and you regret your current positioning, then it is necessary to cut losses and reposition your portfolio. On the other hand, if you believe your investment thesis is intact, then you need to be unemotional, hold your core positions and weather the storm.

I intend to follow the latter path. I see no evidence of a US economic recession – instead I think the current expansion accelerates – nor do I see any reason why a Chinese slowdown will impact the US in a meaningful way. Looking at my own stocks, rather than selling, I feel like buying more. For example, I take comfort in the fact that Citigroup ($C) is trading for 60% of liquidation value, while it is buying back stock and growing earnings.

I believe the stock market is closer to the bottom than the top. The 1998 Russian debt default and eurozone debt crisis of 2011 did not cause a US recession, but they did induce substantial stress in financial markets with 20% stock market corrections. It is possible that in a worst case scenario that the S&P 500 could also ultimately decline 20% from the highs, or fall to 1700. By having 10% of my portfolio in cash, using no margin and having invested capital which I have no immediate need for allows me to sleep well at night and ride out the correction, in case it deepens into a full-fledged bear market.


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