Are You Prepared to Tell Your Clients about the Losses You Will Cause?
Past is prologue. There is a 100% probability that this bull cycle will be followed by a bear cycle. And like so many cycles before, advisors and investors are taking more risk in these final innings of the cycle instead of becoming more cautious as we are at Pinnacle Advisory Group. They are setting the stage for another round of difficult client conversations that will threaten client wealth and client retention. Remember the Tech Bust in 2000, the US Financial Crisis in 2008/2009 and the European Financial Crisis in 2011? So do your clients! Don’t turn the end of this cycle into a bet the business proposition. Now is the time to prepare clients and earn you pay.
The Final Innings
Pinnacle Advisory Group is a “Weight of the Evidence” shop: we review all the evidence (business cycle, valuation, technical, qualitative v. quantitative, top down v. bottom-up) and listen to what the market is telling us. It is currently telling us the bull cycle is intact but to beware, the end is nearing. Two sets of data give us reason to be cautious about overweighting risk in client portfolios.
- Bull Cycle Maturity. The current bull market is old using history as a guide whether you assume the bottom was in 2009 (US Financial Crisis) or in 2001 (European Financial Crisis).
- Valuation. Valuation is reaching levels that strongly advise caution. While valuation is a lousy timing indicator, it has proven a good indicator of future returns. Our research shows that when valuations reach these levels,
future returns are limited to about 2.5% per annum for the next 3-year and 5-year time horizons. The potential return does not pay for the assumption of risk in client portfolios.
Past is Prologue: Planting the Seeds of Future Losses
Bear cycles inevitably follow bull cycles and our research suggests that time is nearing. But rather than acknowledge the evidence, many advisors and clients are forsaking risk management in the pursuit of greater returns. This behavior began in earnest in early 2013 as equity markets approached and exceeded the 2007 highs. After four long years, investors decided “it was safe to go in the pool” again.
We have witnessed this behavior first-hand at Pinnacle Advisor Solutions in our conversations with advisors around the country. And our contacts at Envestnet are seeing the same behavior in their fund flows data as advisors have abandoned risk-managed strategies for return seeking strategies.
Advisors are pursuing exactly the kind of emotional and pro-cyclical behavior that they have been taught to avoid at the risk of client net worth and, eventually, client retention. Advisors employing Strategic Asset Allocation (Buy and Hold) strategies are not engaging in this bad behavior, but they nonetheless are engaged in a pro-cyclical investment strategy which will make their clients and their practices similarly vulnerable.
Time to Earn Your Pay
These late innings of the bull cycle are the most difficult for advisors but this is when we earn our money. The right thing to do is temper client ambitions for greater rewards and to begin to position portfolios for the inevitable downturn. This behavior may be counter to client emotions and may open the advisor to criticism that “money is being left on the table” as markets continue to rise. But feel confident that clients still recall the “risk” they felt so strongly following the Tech Bust, the US Financial Crisis and the European Financial Crisis. Pain (losses) is 2x as powerful an emotion as pleasure (return). With that said they ought to understand and appreciate your efforts to protect them: the time to be aggressive is not 4 years into a cyclical bull when valuations are high.
It’s hard to break from the herd and these conversations may be uncomfortable, but they will never be as hard as telling your clients you led them to the slaughter. Making less money in the final stages of the bull market is never as painful the losses in its aftermath.
Our Game Plan
In terms of client communication, this is exactly the story we plan to share with our clients. In terms of investment management, our game plan is to remain invested but to cap our risk appetite. Specifically, the data we shared earlier tell us not take more than benchmark risk. But because the business cycle, technical indicators and quantitative indicators are still flashing a green light on this cycle, we will remain invested at a neutral posture. We will continue to monitor the “weight of the evidence” for signs of additional deterioration to tell us when to reduce risk below benchmark levels.
This game plan served our clients and our practice well in the approach to and through the Financial Crisis. We are confident that it will prove an effective strategy again in this cycle.
Let Us Help
If you are also concerned that the end of the bull cycle is nearing and are looking for an effective risk-managed investment solution, give us a call. As mentioned in earlier blog posts, Pinnacle Advisor Solutions offers independent advisors a risk-managed tactical investment program that boasts an 11-year GIPS audited track record of beating the benchmark with less risk net of all fees and expenses.