As you know the markets have been quite volatile of late – that’s a polite way of saying that equities have gone down sharply and government bonds have rallied on a flight to quality bid.
The equity markets today sold off on soft inflation figures in China, which underscore the presence of global deflationary pressures. US retail sales were reported off -0.3% in September. Apparently a second nurse has contracted Ebola at a Dallas hospital. And there is clampdown on protesters in Hong Kong
The S&P 500 closed at 1869 today, down 8% from its all-time high this September. Small cap stocks have done worse. International stocks as measured by the MSCI ACWI non-US index are off 10% from their highs a few months ago. WTI oil is trading at $80, down 25% from its July high. The 10 year Treasury traded below 2% earlier this morning compared to 3% at year end. In other words bond prices are up strongly.
For the record it’s not unusual for stocks to fall these amounts during the year. JP Morgan notes that since 1980 the largest stock market drops from peak to trough during the year have averaged -14.2% while the median decline has been -10.0%. Annual returns have been positive in 26 of these 34 years.
The main catalyst for recent declines has been slowing economic growth mainly out of Europe – they are flirting with a third recession in six years and deflationary forces. And while earnings have been decent, valuation in America and Europe left little room to absorb “bad news.” Of course various geopolitical conflicts have been on again off again, unsettling investors.
It seems to be an overreaction to us. The US economy is doing fine; company balance sheets are solid and earnings remain steady. There is much less leverage in the system compared to five years ago. The US budget deficit was just reported to have fallen below 3% of GDP – down from 10% four years ago! We are all not going to die from Ebola, ISIS will not take over the Middle East, and Iran will not get the bomb among other worries. I’m being facetious. I do believe these are serious but very low probability events. In so far as Europe is concerned, it is weak but bond yields are at two century lows! It’s pricing in a Great Depression which is also unlikely.
There are no magic investment strategies to counter the volatility other than diversification, time and a disciplined investment process. Clients know that while we view bonds as “rich” – bond lingo for overvalued – we do own them in asset allocation accounts as insurance against equity market declines. Some have asked recently about “hedging strategies” but frankly while that sounds good it is just another way of timing the market. You can sell stocks or “hedge them” by shorting stock futures. It’s the same thing. About the only pure “hedge” is to buy put options on stocks, but you must pay premiums (yep, it’s just like buying insurance) to do that. Our basic view is that you should stay diversified to weather these squalls so as to enjoy the higher returns in the equity markets over time. You must shoulder market uncertainty in order to reap the rewards.
We recognize (actually we preach!) that selecting and maintaining an appropriate asset allocation is a key pillar of a successful investment strategy. To help our clients select and maintain the appropriate asset allocation our investment committee develops a long term (7 year) strategic investment outlook with corresponding long term expected returns. Although no one is capable of accurately and consistently predicting macroeconomic events such as the ones we are currently experiencing, our long term outlook reflects muted global economic growth and inflation expectations.
So, what are we doing now? Double checking portfolios to make sure they are diversified and aligned with long term strategic objectives. Then batten down the hatches and wait out the storm.
Chief Investment Officer