Prepare Your Retirement Portfolio for a Downturn

Perhaps the only thing that we can all agree on is that we don't know what's going to happen next. On February 11, Standard & Poor's 500-stock index was down 11.4% for 2016, the worst start to a year in stock market history. (Note, however, that the market has certainly had much worse declines over shorter time frames. But because this drop happened to start the year, it seemed to capture our collective attention more than others.) That the market fell should have come as no surprise to anyone who had been paying attention at all these last seven years. The surprising thing is that it didn't happen sooner. What's more surprising, to me at least, is that those losses have been erased as of late March.

In my book, Wall Street's Just Not That Into You, An Insider's Guide to Protecting and Growing Wealth (opens in new tab), I talk about the unpredictability of the market. Stocks routinely go much, much higher than could have been previously thought possible. They can go so much higher, in fact, that investors and financial advisers forget the other reality—that stocks can go much, much lower than previously imagined possible.

In the first chapter of the book, I write about my "coming of age" (please pardon the drama implied with that phrase) in the investment business. Like nearly 100% of financial advisers, I was taught that buying and holding a diversified portfolio of stocks and bonds was always the right thing to do for your clients. There was no circumstance that could present itself in which a deviation from the previously determined asset allocation should be altered. The only thing that could precipitate a legitimate change in the asset allocation was a change in the life circumstance of the client. Outside of that, a change in strategy was paramount to market timing or even day trading.

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If the last 16 years has not altered your view of that belief, and by extension the way you invest your money, the next ten years may be very painful. That's right, I said, "may," so yes, it also may not be painful.

I was speaking to a group of very smart professionals last week about the current market and how it relates to market behavior historically. I said that the market's current cyclically adjusted price-earnings ratio (also known as the Shiller P/E, named after economist Robert Shiller who devised it as a method of normalizing earnings) is about 24. The high of the multiple was 44 (in 1999), and the low was 4.5 (in 1922). One of those in attendance said, "So it's not that high, then." But the median P/E, going back to the 1880s is 16.4, so it's certainly on the higher side.

The market decline that ended in March 2009 was the first bear market bottom (if indeed it was the bottom) in which the multiple didn't go to 10 or below. In fact, the low P/E in March 2009 was 15, just a tad under the median. You may ask, "Why do you suppose the market multiple didn't trade down to historical levels then?" While we can't be sure what caused the higher low in 2009, we can be fairly certain that the Federal Reserve's monetary policy and the effect of quantitative easing (which pumped hundreds of billions of dollars into the economy) played at least some role in the market finding its bottom when it did.

"Could there be a new paradigm?" asked another person in attendance. In other words, could the low end of the P/E range now be in the mid-teens and not the mid-single digits? The answer to that question is a resounding "yes." A fundamental change may have occurred. That's the only honest answer to that question because there is absolutely, positively no way to know right now.

What does this mean for you? Let's look at it in a real life example: Suppose you are 62 years old. You have $5 million in liquid assets, which includes everything but your house and personal possessions. You intend to work five more years and plan to save another $500,000 over that time. If 20 times earnings is the new black (the low end of the P/E scale), then you may earn 5% a year and have about $7 million when you retire. Not bad.

If, however, the low end is 12 times earnings (and assuming earnings don't compress), you may end up with just $2.75 million at retirement. You're certainly not poor, but you aren't going to be living the life you'd planned with that amount. You can guess that your situation would be worse off if multiples go into the single digits.

Given these possible outcomes, ask yourself, "Is the chance of having 50% more money in five years worth the risk of having 50% less money in five years?" (While the outcome is likely to be somewhere between those extremes, it is the negative extreme that the prudent investor prepares for.)

My answer to that question is the same as it is for all my clients: Going down by 50% is way, way worse than going up 50% is good. If your answer is the same, what should you do with your portfolio?

My current baseline allocation is:

• 20% Cash
• 30% Strategic buy and hold, which would include an allocation to the typical long-only mix of stocks and bonds, as well as traditionally non-correlated strategies such as merger arbitration and global macro.
• 20% Monthly relative strength system: We start with a population of exchange-traded funds that cover the global markets and rank them according to their strength relative to one another. Each month we invest in the top two ETFs, provided they are each trading above their short-term moving averages. If one or both of the top two ETFs is trading below its moving average, that percentage of the portfolio is shifted to cash or cash equivalents.
• 30% Quarterly relative strength system: We essentially follow the same process as explained above, except the calculations are run on a quarterly basis.

While there is no way to prepare for every possible outcome, this allocation accounts for the big unknowns. If 20 times earnings is the new black, then we can still enjoy the continued appreciation of financial assets, albeit to a lesser degree perhaps (though not necessarily). But if markets do what they've done in the past, we are set with less exposure to the falling markets, as well as systematic ways to further reduce exposure and side step much of the possible carnage. That's diversification.

Roger Davis is CEO of Woodridge Wealth Management, LLC (opens in new tab). He lives in Los Angeles with his wife and two children.