Last Call

This is the last article in my Trump Trade War series. In it, I address investment strategies to mitigate what I perceive as the worst potential effects of the Trump Trade War for investors on a three to nine-year investment horizon. This is by far the hardest time period for which to devise investment strategies due to the uncertainty surrounding the next potential recession and Bear Market. However, I felt I owed it to my readers who’ve stuck with this series thus far, and to those who also find themselves within this investing window.

Recap

In case you haven’t read the other three articles in the series, here’s a re-cap. In the first article, I discussed President Trump’s misguided tax and trade policies and predicted they would make the next economic downturn that much worse. His late business cycle moves are like pushing a night out with friends way past dinner towards heavy drinking and revelry; sure it feels great at the moment, but the hangover is that much worse in the morning. I also opined Trump’s policies might even hasten an already overdue recession and Bear Market. My selling point was that these issues matter to every potential retiree, pension earner or not, who has an investment portfolio they intend to use to help fund retirement.

In the second article, I addressed Risk and Risk Mitigation. Although Risk is something I’ve written about previously, it’s a critical concept every investor must understand so it was worth a re-visit. I also discussed my investment philosophy; which is something I hadn’t specifically addressed in prior articles.

In the third article, I covered investment strategies at the two and ten-year ranges to mitigate the worst effects of the Trump Trade War based on Risk and my investment philosophy. Nothing I’ve proposed to this point is outlandish. In fact, it’s all based on investing and economic fundamentals. No shocker then that many of the strategies I discuss in these articles can be applied independently of any single macroeconomic driver. In reality, I simply used my concerns over the Trump Trade War and tax policies as a reason to discuss economics and investing. Both of which I love to read about and discuss.

Caveats and Qualifications

Again, I am neither an investment professional nor do I play one on TV. Nor am I writing about anything more than hypothetical situations. If you find yourself in a similar situation or time-frame to what I describe; I advise you to use my ideas as starting points for your own research. Alternatively, you could choose to discuss my ideas with an investment professional. As always I recommend talking to a fee-only, sworn fiduciary, and registered Certified Professional Planner (CFP) or a Chartered Financial Analyst (CFA). This limits conflicts of interest.

I would also say that the further along the investment horizon people find themselves, the more likely it becomes that they could ride out the effects of the next recession — without doing anything major to their investment portfolio. I hope that doesn’t sound like a cop-out, but when you get into a nine-year investment horizon, you are talking beyond the average length of an entire U.S. business and market cycle. Thus, if a recession started tomorrow, a person with a nine-year horizon would very likely see an entire recession and recovery with an accompanying Bear and Bull market cycle, prior to withdrawing their money for use.

Risk Review

Just so it’s fresh in everyone’s mind, the main Risk all retirees want to avoid is running out of money (too early) in retirement. Regardless of whether or not an investment portfolio acts as the only means to fund a retirement, or as a supplement to a pension; I presume that running out of money in a portfolio would prove catastrophic. Within retirement, a certain type of Risk that impacts portfolio success or failure raises its ugly little head in the form of Sequence of Return Risk (SRR).

As I defined in my previous article, SRR is the mathematical probability that if a market crash occurs early within the withdrawal life-span from an investment portfolio (e.g. a person starts retirement withdrawals from their portfolio just as the market crashes), then the underlying portfolio will suffer irreparable damage.The time frame in which SRR is mathematically at its highest probability to cause this irreparable damage is within one-year on either side of a major market crash. Thus, if a person were to stop accumulating and start withdrawals at a normally sustainable rate for a certain time period from their portfolio within one-year of a market crash, it’s highly likely their portfolio will run out of money quicker than planned.

Safe Withdrawal Rate Theory

As I also addressed in Part Trois of this series, the primary method to overcome SRR is to save and invest enough in your portfolio to allow the use of a Safe Withdrawal Rate (SWR) in retirement. SWR theory essentially proposes that when tested against all historical performances of the U.S. stock market, an investment portfolio intended for a specific length of time with a specific mix of stocks and bonds has a maximum withdrawal rate that it can successfully sustain … no matter what happens to the market. Since this SWR takes SRR into account, then an investor needn’t worry about SRR as long as they stick to withdrawing in line with their portfolio’s SWR.

Can You Trust the SWR Theory?

Of course, not everyone trusts the SWR completely, because no one knows how bad a future market crash might be. Some might go outside historical precedence. The Trump Trade War scenario I painted in my previous articles in this series, would do nothing to allay that fear. It’s also become apparent through the work of bloggers and financial specialists like Big ERN, Michael Kitces, and Wade Pfau that previously believed SWRs for certain stock-bond mixes over certain time-frames were compromised in the 2000 market crash caused by the Dot.com bubble bursting.

In other words, all other circumstances being equal, the portfolios of retirees from 1999 and 2000 won’t safely sustain withdrawals at their previously predicted rate. Meaning retirees in the 1999 and 2000 cohort that retired within one year of the Dot.com bubble crash, who never made another dollar in their life outside of what was in their retirement plan, and spent in line with their plan; will either have to withdraw less now, or run the serious risk of their portfolio failing in the future. It’s too early to tell if the same applies for retirees from the Great Recession from 2008.

Hedges Without Benson

As result, numerous personal finance bloggers, financial specialists, and early retirees have taken it upon themselves to create hedges against the worst possible outcome for anyone unlucky enough to retire in the years of maximum SRR risk — including themselves. I covered two such hedges in my last article. The trick for any investor/potential retiree is to not transition too early to their ideal stock-vs-bond ratio in order to enact their SWR and their hedge.

Doing so limits future return potential (if a market crash doesn’t hit when expected), which translates to a longer timeline required to reach their desired portfolio target amount and retirement date. That’s based on the fact that research shows that the highest average rate of return for simplified portfolios (the type for which I advocate) is 90% to 100% stocks made up of a well-diversified market representation like an S&P 500 index fund.

How Bonds Differ from Stocks

Although I don’t want to get too heavy into bond performance vs. stock performance; I’ve been remiss not to address their crucial performance differences — particular those of bonds. Bonds can be bought and sold on secondary markets by their original owners. They needn’t be retained for the entire contract period by the original owner. In fact, most people who consider themselves bond “holders” don’t actually hold bonds. They invest in them through secondary markets via mutual funds or ETFs. To create a secondary market, buyers and sellers must come together and agree on a price for the original bond based on its current value. A major portion of that current value is determined by current interest rates for new bonds. So it’s important to note the following points:

• If the current interest rate is higher, the older bond at a lower interest rate is worth less.
• If the current interest is lower, an older bond with a higher rate is worth more.

This creates an inverse relationship between bond prices and interest rates on the secondary markets! Thus, if governments start cutting interests rates (like they tend to do during a recession), bond prices tend to go up on secondary markets.

Is this a war bond poster, or a condom poster?

Demand For Bonds

Here’s the second point which drives bond performance and price: demand. Bonds are desirable based on their predictability and lack of volatility … if they are held until redemption and assuming the borrower does not go bankrupt. Investors, especially large institutional investors like Pension Funds, might require this predictability for any number of reasons. Commercial investors tend to buy bonds when they can no longer withstand the volatility of the stock market, such as during a Bear Market. Periods of high bond demand also (typically) creates upward price pressures in the secondary markets. Thus, there are limited windows in each market cycle where people sitting on a large percentage of bonds can sell them through secondary bond markets to generate cash at a premium based on interest rate cuts and demand.

Finally, it’s important to note that stability and predictability come with a cost. That cost is usually realized through lower rates of return than what stocks return to an investor over time. Also, outside of periods of high demand and rapid interest rate moves, bond prices don’t tend to fluctuate too much. So, the opportunity to make money from bonds (outside their interest rates) just isn’t there as often. Thus, there’s a balance to be struck in any portfolio at any time between the higher returns stocks provide over time with their volatility and the lower but more dependable returns that bonds provide. As I noted in Part Deux of this series during my discussion on Risk Capacity vs. Risk Tolerance, that balance depends on the goals and timeline of the investor.

No Timing

As a result of everything I just reviewed above, the importance of implementing any investment mitigation strategy to a Trump Trade War caused recession comes down to timing. Ironically, for those of you who read Part Deux of this series, you know I’m not a big believer in timing the market. While on paper it can mathematically produce higher rates of return than the market average; I’ve yet to see any definitive proof that it works at a practical level (i.e. the commercial investor level). Thus, if you ask me, trying to time the date, week, or even month that the market will drop into Bear territory is a mug’s game.

In fact, market timing has been shown to cause more harm than good to the average investor’s portfolio. I’d be wary of anyone who says otherwise. If they do, ask them to show you a proven record of successfully predicting three or more Bear markets in a row while betting with their own money.

The Indicator

That said, there is at least one macroeconomic indicator that provides a fairly accurate gauge as to when the next recession is coming. It’s not accurate at the micro level, so I wouldn’t use it solely to prompt my portfolio moves. However, it’s uncannily accurate within an 18-month window, which could help people determine if their intended retirement date lines up with the maximum vulnerability period for SRR. That, in conjunction with a Risk Capacity assessment, may help an investor and retiree determine what to do.

Of course, that assumes Bear Markets accompany recessions. As I addressed in part one of this series, research shows Bear Markets and recessions are strongly correlated, with plenty of examples of causation (i.e. one causing the other to occur). Thus, I believe this indicator for recession is the best proxy out there that signals the coming market crash caused by Trump’s Trade and Tax policies. What is the indicator? It’s an Inverted Bond Yield Curve.

Inverted Bond Yield Curves

What’s an Inverted Bond Yield Curve? It’s the name given to the rare occurrence when it becomes more expensive for the U.S. government to borrow money from investors in the short term (i.e. less than 10 years) that it does in the long term (i.e. 10 years or longer). The reason it’s so important is that every time the U.S. yield curve has inverted since the 1960s for at least one quarter (i.e. 3 months) a recession has followed within 18-months. Not most times, or even sometimes, but EVERY time.

Now, before you groan that I’m about to write about more economic mumbo-jumbo that you have zero interest in or hope of understanding; rest assured I’m not. Although, if you’ve stuck with me this far, you probably like that sort of mumbo-jumbo! In any case, not this time. Instead, I’m referring you to a ten-minute podcast that covers this topic in detail with the person who discovered the phenomenon. The podcast is Planet Money’s “The Indicator“, which explains important economic issues in terms that dummies like me can even understand. Which is another way of saying, that it’s worth a listen even if you’re not interested in, or don’t know about economics.

Doubters

One reason I suggest you listen to “The Indicator” podcast is due to the skepticism surrounding whether or not the yield curve can continue as a reliable indicator for future recessions. As always, some people are claiming “this time is different“, and their arguments are not without merit. However, I’m pressing the “I believe button” on the yield curve issue, and use it as my main reason to instigate (or not instigate) a 3-to-9 year Trump Trade War Investment Mitigation Strategies (T-TWIMS).

The Concerns of a 3-to-5 Year Investment Horizon

A person who finds themselves on a 3-to-5 year investment/retirement timeline probably stands the most to gain by tracking the bond yield curve. I say that because the Trump Tax Cut could provide the current Bull Market a longer than normal life-span. That, in turn, could push the eventual Bear Market a year or more into the future. Of course, the impact of Trump’s Trade War could very well shorten the life of the current Bull Market too. The bottom line is that no one knows for sure. As a result, tracking the bond yield curve becomes extremely important for anyone intending to retire and start withdrawals from their portfolio over the next five years.

For argument’s sake, let’s say the current Bull Market runs another year or more due to the tax cuts. Let’s also assume that at some point late in that time-frame the bond yield curve inverts for a quarter. Based on that inversion, one should expect a recession anywhere within the following 18-months. That inversion quarter might cause the Bear Market which in turn would cause the recession. Or, the recession may cause the Bear Market. Either way, that puts the worst effects of a recession and a Bear Market partially-to-fully within a 3-to-5 year window.

The Easy 3-to-5 Year T-TWIMS

So what could a person do if they find themselves with a 3-to-5 year investment window, and the scenario plays out as I described above? Well, part of that depends on just how long into the future the person has before they start to make withdrawals. Some of that also depends on whether or not a person has already hit their required SWR total. If they’ve hit the total amount required to engage their desired SWR, and they need the money closer to the front-end of the 3-to-5 year window; then the safest thing might be to transition to their SWR’s required stock-to-bond ratio when the yield curve inverts.

At worst, by doing so, they miss up to 18-months worth of optimized growth prior to the recession and a Bear Market hitting. Which is nothing to laugh at because it turns out stocks typically keep climbing after the yield curve inverts. However, I’m not advising a person sell all their stocks. They simply need to transition to their SWR’s required stock-to-bond ratio. Since they’ve already saved the required amount to enact their SWR, missing out on a few extra percentage points of return is simply like missing a few sprinkles on a doughnut. The upside is that a person avoids a situation where they need to make withdrawals from a portfolio over-weighted in equities while the stock market is dropping, or only just beginning to recover.

The Alternative to Alternative

Alternatively, if by the time the yield curve inverts a person finds themselves no more than one year away from needing the money, they could enact one of the two-year T-TWIMS I described in my previous article. I personally would choose the equity glidepath option. In fact, I probably will do that if I find myself working three more years (vs. my desired two) and retiring within a year of the bond curve inverting.

The Harder 3-to-5 Year T-TWIMS

Finally, what happens to someone within 3-to-5 years of retiring who hasn’t already hit their savings mark for their desired SWR when the bond yield inverts? I hate to say it, but they probably aren’t retiring in 3-to-5 years. The odds are stacked against them that they could reach their desired savings goal prior to a market crash occurs.

Certainly, they could attempt to time the market, take the gains for as long as possible, and then go ultra conservative with a heavy percentage of bonds once they’ve stomached as much of the upside ride as they can take. However, the average person attempting this strategy likely would get caught by a sudden market drop prior to selling. I say that because selling winners when the market is up, goes against human nature.

Devil’s Advocate

For argument’s sake though, let’s say a person was able to successfully implement the first leg of the above high-risk strategy; what should they do then? First, they should ensure that bond prices went up. Bonds typically perform out-of-cycle from stocks, but not always. However, in this scenario bond prices should go up when stock prices tank.

If that happens, and a person finds themselves sitting on a heavy bond portfolio that is up significantly, then they should start selling bonds. That hypothetical person should then use the money from the bond sales to buy back stocks while they are on “sale” due to the market drop. Doing so would be the epitome of a “sell high, buy low strategy”.

Don’t Try This At Home Kids

Again, let me emphasize how risky this strategy is. It violates my personal investment philosophy in a number of ways. Specifically, it’s complicated, and my philosophy is to keep things as simple as possible. Secondly, it requires discipline … A LOT of discipline. In fact, it requires a double dose of discipline because you have to sell winners and buy losers twice — which, again, goes against human nature.

Don’t think my math adds up? Well, consider this. First, a person must sell stocks while they are riding high before a crash and buy bonds while they are (most likely) languishing. Then this strategy requires the discipline to sell those bonds after they’ve risen in value and made a hefty profit. Finally, it requires this mythical ultra-disciplined person to buy stocks again, which will be down and potentially still dropping, in order to ride them back up again. My only piece of advice for anyone attempting to enact such a risky stratagem is to set percentage targets that force a sale when the values of the winners rise a certain amount and force a buy when the losers drop a certain amount. Otherwise, good luck!

What You Should Do Instead

Here’s my advice, free of charge, for anyone whose hasn’t hit their savings goal prior to a market downturn. Walk over to the mirror, look yourself in the eye, and ask these two questions:

• Am I willing to work for half a decade or more through the next market recovery?

If no, then:

• Am I willing and capable of living on less in retirement?

Of course, that assumes you’ve actually done the hard work to determine what your spending needs will actually be in retirement. If you haven’t, then check out the earlier articles in my Planning section. However, assuming you’ve done the hard work, you got a choice to make. Work longer or retire on less.

Now the good news! Nothing says you need to work at the same job if it’s making you miserable. Assuming you’ve been saving aggressively (because you’d have to be in order to be within 3-to-5 years of hitting your SWR goal) then it means you have a lot of FU money. You could always transition to something less stressful, more fulfilling, or just plain easier that pays the bills. Doing so through a market crash would give your portfolio time to recover, and maybe even grow closer to that all important SWR number once the market recovers.

That Was Good News?

Alternatively, if you’re happy in your job, simply keep investing. The market will recover at some point, and it pays well to plow as much money into stocks when they’ve dropped. Don’t be afraid to transition to a more conservative stock-to-bond ratio in your current portfolio during the stock market’s the run-up, after a market inversion, if your Risk Tolerance can’t handle large dips in portfolio value. Just make sure that any new money you save during a market crash gets invested into stocks as they dip.

After all, you’re getting a previously premium priced product on sale. The price will recover eventually. Once it does, you’ll have experienced significant gains from those stocks bought on the cheap, which will put you that much closer to your desired SWR portfolio number. More importantly, you’ll be beyond the 1-year window on either side of a market crash where SRR plays such a crushing role to your portfolio’s chance of success or failure. At that point, it should be an easy path to your savings and retirement goal.

A Quick Word About 6-to-9 T-TWIMS

As I mentioned at the top of this article, once a person starts to look at a 6-to-9 year timeline for their retirement and investment needs, they’re really talking about another complete market cycle. Thus, I don’t think there’s much need to worry about the Trump Trade War market crash. Even if this Bull Market runs magically long (say three more years), that stills puts a person with a six-year horizon two-years beyond the crash. My best advice is to consider your Risk Tolerance and Risk Capacity, and adjust your portfolio accordingly as you get closer to retirement. In the meantime, take advantage of those stocks going on sale by plowing as much saved money into them during the next crash.

Someone with a nine-year horizon will probably need to worry more about the crash after next, rather than the current one approaching. Thus, if I had a nine-year investment horizon, I’d stay aggressive as long as possible, buying up as many stocks on the cheap during the Trump Trade War crash as I could afford. Nothing I’ve researched while writing these articles makes me believe that the Trump Trade War induced crash will still be around in nine years, so enjoy the ride.

Conclusion

That wraps up my Trump Trade War series. This article was far more in-depth than I ever thought I would get with investment discussions on this blog. It was fun to discuss all the “what ifs”. Remember though my investment philosophy is to keep things as simple as possible based on Risk Capacity and investment timelines. If your retirement timeline places you in the unlucky window of retiring within 1-year of a Bear Market, remember the dangers of SRR and mitigate accordingly.

However, you should also remember that the more complicated your moves get, the more damage you’re likely to cause to your portfolio through a mistake or mistiming. Remember the Dalbar study and its findings. The more active you get, the lower your returns are likely to be. If you choose to ignore that advice, then at least remember that human nature lends itself to get caught up in the fervor of the market right before a crash, and then panic afterward. If you can fight those feelings, maybe you got a chance. Maybe!