Prepare clients for the inevitable market correction

As 2013 draws to an end, and advisers and their clients reflect on the year, many would be…

As 2013 draws to an end, and advisers and their clients reflect on the year, many would be forgiven for thinking the holidays have come early. After all, with major indexes up more than 25%, what’s not to be cheerful about?

Yet before breaking out the eggnog and toasting to a great year, it might be good to review your clients’ retirement plans.

Many analysts argue that the current market still has legs and may continue to rise well into 2014, while others believe that a correction is long overdue and investors should brace themselves for a pullback. Both are possible, but we don’t believe in market predictions. What we do believe is that regardless of when a correction happens, it will eventually happen, and advisers should be ahead of it.

Consider the following:

• The last two bull markets lasted an average of 4.5 years. The current cyclical bull is at 4.75 years.

• The average mean return of the last two bull markets has been between 127% and 150%, depending on the index. The current run is 166+%.

• The average Shiller price-earnings ratio is 16. The current Shiller P/E is 25.

• Tobin’s Q, a ratio of market value to the asset value of the S&P 500, is 1.02. That is 50% higher than its historical mean, and since 1950, the only time it has been higher was during the tech bubble. It didn’t even reach that level during the housing bubble.

None of this should send investors sprinting to the sidelines, but history has a tendency to repeat itself, and these statistics put a slight damper on the current market euphoria. So assuming that the market pulls back at some point, what should advisers be doing with their clients’ retirement assets?

For starters, sit down with clients. It’s a good practice to meet with them at the end of every year, but with market clouds looming on the horizon, it’s especially important right now.

With 2013 shaping up to be a banner year, this year’s conversation will likely be a pleasant one. One thought is to use this new good will to your advantage and encourage clients to consider taking some money off the table and moving it into more-conservative asset classes. They may miss some market gains, but wouldn’t that be preferable to a steep loss in account value?

Second, beware of fixed income. Investors have long used fixed-income strategies to protect against market pullbacks, but with rates at practically zero, they really have only one way to go — up — and when rates rise, fixed-income investments share the pain with equities.

Most investors have never experienced a persistent rising-rate environment and a bond bear market. For this reason, you should consider other ways to protect portfolio value when the next bear market hits.

Focus on risk control. No investment is bulletproof, but certain strategies do hold up in declining market conditions better than others. Discuss with clients investment options that are designed to protect them during a correction. This can include alternatives such as absolute return, real estate or commodities, which typically generate non-equity-based returns. Also consider defensive strategies with flexible equity components that allow for adjustments in equity exposure within the portfolio, based on market risk levels.

Diversify beyond asset class. As we learned in 2008, asset classes often move in sync, especially during periods of market and economic stress, and they don’t always offer the level of protection and safety that investors have come to expect. That’s not to say that we’re expecting another 2008; far from it. But diversifying beyond asset classes into truly noncorrelated investment strategies can help provide portfolio protection.

Finally, it’s imperative to stress to your clients that mitigating the emotional aspects of investing is the key to long-term success. Markets will continue to move up and down over time, and as these down markets take place, our instinct to make dramatic conservative decisions is almost always wrong. Keeping this emotional component in check and recognizing its negative impact may prove to be the difference between long-term success and failure.

Brad Thompson is chief investment officer, and Jeff Keller is vice president and director, of defined-contribution sales at Stadion Money Management.