Be Prepared

August 28, 2018

By Sarah Yakel

As I write this blog, Hurricane Lane is approaching Hawaii and residents are facing the largest storm in 26 years. News footage is dominated with charts of the storm’s path, balanced with residents buying water and other staples or evacuating.

When this is posted, Hurricane Lane should be well past Hawaii and hopefully all residents stayed safe and damages were as minimal as possible. Usually, we write our blogs fresh every week, but in this case, I am writing this blog early in preparation for heading out on vacation in a few days.

When I head out of the office on vacation, we usually use the opportunity to test our own disaster recovery plan, and I am not allowed to touch base with the office for a few days, just to make sure everything runs smoothly without me (which it always does, thanks to the great teamwork here at Meridian! 😊). The SEC makes us test our disaster recovery plans annually, as we need to know—with reasonable certainty—that our back up plans work BEFORE we are in crisis mode. And this totally makes sense—trying to form a plan in the middle of a disaster is just a bad idea.

Likewise, planning for ‘disaster’ in a portfolio (i.e. stock market decline) should occur before giant sell offs occur. There is no good way to time the market and avoid disaster, so we work diligently to prepare our clients’ portfolios to be able to withstand declines all year round.

Currently, we are working on preparing clients for what appears to be the end of this economic cycle. Most economists agree that we may have reached the peak of this current economic expansion and are now moving into the late cycle. Fidelity has a great visual of the characteristics of each part of the business cycle:

The last rounds of economic data that we have received indicate that the US economy is squarely late cycle—we are starting to see pressure on earnings, interest rates are rising, credit spreads are tightening. None of these indicate an imminent market crash, but combined, they do start to signal a market shift.

In the late cycle of an expansionary period, the stock market can continue to do quite well, but risks usually begin stacking up—which we are seeing with high geopolitical tension, interest rate increases, mid term elections, tariff talks, and more. All of these give weight to planning now for the next market downturn, as it seems it is now on the horizon.

Here are three things that we typically look at when preparing a portfolio for a future disaster:

Any obvious imbalances—these could be economic or portfolio specific. An economic imbalance would be something like the housing bubble/credit credit crisis. Clearly, the system was flooded with home loans that didn’t make sense, backed by property values that also did not make sense. We do not see any dramatic economic imbalances at the moment. Portfolio specific imbalances may be a very large concentration in one stock or one industry. In 401Ks, we often see a large concentration in employer stock, which leads to an overall imbalance of risk for our client that works for that company, gets their health insurance through that company, and also has their retirement funds tied up in the wellbeing of the company!
Overall risk level—we look at the risk inherent in a portfolio through the lens of how much risk does each client HAVE to take to meet their goals, how much do they WANT to take, and how much are the ABLE to take. If any of those are over the desired limits, now is the time to tighten them back to the appropriate level!
How risk budget is spent—once we have made sure that the overall risk level is appropriate, we look for the most prudent method of ‘spending’ that risk budget. In fixed income, it does not make sense from a risk/return prospective to buy long-term bonds as short-term interest rates are nearly as high as longer term rates. In the equity market, some sectors perform better than others at the end of a cycle, and overweighting or underweighting these may be prudent—thanks again to Fidelity for the great chart: