October 2017 Market Commentary

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Preparing for a Market Correction

Overcoming Animal Instincts with a Rational Process

The U.S. stock market has enjoyed an unusual degree of growth and stability since the Great Recession in 2008 when the market shed almost 50% of its value. Not only has the market recovered, the S&P 500 has reached new highs that are almost 60% greater than the market peak before the big decline. This naturally begs the question, “when will the market correct again?”

One thing we know is that the market will correct at some point. The following chart illustrates how often corrections occur, and how steep they can be. It also paints a promising picture, since the market generated positive returns in 28 of 37 years, despite negative declines every year, with an average decline at some point during each year of -14.1%.

MC October 2017 1-S&P Intrayear

The data demonstrates that the market overshoots fair value on both the upside and the downside. What no one knows, however, is the date, time, and amount the market will correct.

Our inability to forecast market corrections should not create fear, nor dissuade us from participating. As the market proved on the heels of the meltdown in 2008, it is resilient. What we should do, indeed what we must do, is exercise diligence about understanding the amount of risk we are taking, how our portfolios are constructed, and how they are managed.

SOME HISTORICAL PERSPECTIVE

The Mob Rules. This is another way of saying the market (collection of all opinions) will suspend traditional thinking and adopt alternative beliefs about valuation approaches. This happened in the 1970s with the Nifty Fifty, in the 1980s with real estate, in the 1990s with technology stocks, and in the 2000s with real estate again. Each run-up to the correction was rationally explained (after the fact) by a change in some underlying factor of valuation. What failed to materialize was the purported permanence in that factor’s persistence.

The 1970s introduced the rise of conglomerates and the ability of firms to use their richly valued equity to purchase any business. With valuations stretched, the market was shocked by the end of the gold standard, the oil embargo, and price controls leading to precipitous declines starting in 1973 through the end of 1974.

The runaway inflation of the late 1970s pushed money away from financial assets into real assets. The result over the course of the 1980s was a boom in real estate prices. Yet, when commodity inflation waned, it left real assets overvalued, and investors exposed to a major correction.

The 1990s ushered in the era of technology stocks, and gave birth to the strategy of paying for growth and not earnings. There was a theory that the ‘new’ economy would replace the historical real economy players. A single catalyst for the rapid decline technology valuations in 2000 is hard to pinpoint. The numerous accounting scandals did not help, but in the end the market may have toppled under its own lofty valuations.

Our most recent market correction in 2008 followed a real estate peak in 2006. The peak was reached via artificial consumption created by tapping home equity, which turned out to be unsustainable.

MC October 2017 2-Market corrections happen

So what does recent history tell us about the market today? Only that a correction will occur in the area that, retrospectively, was the most overvalued. Will it be technology catching up with the real economy’s limitation on growth? Municipal bonds caused by their state or city’s inability to make pension payments? US equities due to their relative overvaluation to global equities? Commercial real estate due to its declining demand function from the gig economy?

PREPARING FOR A MARKETING CORRECTION

Conversely, is technology cheap because it will change the real economy? Are municipal bonds stable because states can change their tax rates? Is real estate cheap because of the under investment in infrastructure and the willingness of people to put a greater stock of their wealth into their residences where they can now consume the work, food, and entertainment that used to be consumed elsewhere?

We can guess at when we might see a correction, or what area of the economy will feel the greatest pain, but the tides change daily and the markets discount the impact of the changing tides every day. Forecasting the event is futile and when you look at long term market prices it does not seem that important.

The more productive way to prepare for a market correction is to always be prepared. This means the processes of managing money must be followed every day as if a correction could happen on any day. If you cannot forecast you must prepare.

HOW WE CAN HELP

1. Setting a Risk Objective

Choosing and maintaining discipline around an investment objective is the primary protection against market volatility. Our portfolios are constructed around a level of risk using historical volatility (standard deviation) as a measurement for that risk. Following are the five objectives we use with the respective levels of targeted standard deviation.

MC October 2017 3-Distinct Risk obj

Having a distinct quantifiable risk metric for each objective allows clients to better understand the potential volatility they’re accepting in pursuit of their goals. It also enables us to systematically manage their portfolio to that expectation. So, even though we don’t know when the market may correct, or how much, we can know that a Moderately Aggressive portfolio will generally correct 2x that of the Moderately Conservative portfolio. For example, a 2-standard deviation correction (something that statistically would occur once every 20 years) would leave the Moderately Aggressive portfolio down 24% versus a Moderately Conservative portfolio own 12%.

Perhaps the most important thing we do for a client is to make sure we and they understand their tolerance and capacity for risk. Risk tolerance is a subjective measure of a client’s attitude and appetite for risk. Often overlooked, though, is a client’s capacity for risk, which means knowing how much downside volatility can be endured without altering the portfolio’s asset allocation. Understanding both capacity and tolerance for risk improves the likelihood of staying the course during volatile periods, which is crucial to protecting value.

2. Staying the Course

Perhaps no single factor has a more detrimental impact on client outcomes than the twin sins of greed (chasing performance) and fear (bailing out after a market correction). Both impulses are natural, but are also futile since they are reactions to what has already occurred.

In fact, the following graph illustrates the danger of this behavior. Over the 20 year period ending in 2015, investors dramatically underperformed the very investments they were using during the period. It defies logic until you consider that the investor’s results reflect timing decisions. In other words, in order to achieve the returns of each respective asset class would mean having been invested for the full period. In fact, investors move between asset classes, and consistently at inopportune times. They systematically bought high, after outperformance, and sold low, after poor performance – a recipe for destroying value.

MC October 2017 4-20 year annualized

Despite the evidence against performance chasing and bailing out of the market, managing emotions is not easy. A skilled advisor that brings objectivity and perspective is a valuable ally in overcoming the tendency to overreact.

3. Rebalancing Portfolios

Staying the course does not mean standing pat. Once a client’s risk objective is established, preserving fidelity to the objective requires careful oversight to understand how market movements and cash flows have affected the portfolio’s profile relative to the objective, and rebalancing when needed to maintain alignment with the objective.

An additional benefit of rebalancing is the probability of selling high and buying low. This can bring additional returns to our long-term strategic allocation, by inherently leveraging a strategy known as ‘contrarian investing’. The essence of the strategy is to sell assets that have outperformed, outgrowing their target allocation, and reallocating the proceeds to assets that have underperformed to reestablish their target allocation. As logical as it is, the discipline of selling outperformers in favor of underperformers requires some fortitude.

In many cases, industry conventions for rebalancing are also geared more so to what’s efficient for the portfolio manager, than what‘s best for the client. First, rebalancing is often done based on a calendar schedule, rather than monitoring client portfolios and acting when opportunities are presented to harvest tax losses, or when acceptable deviations from the target portfolio have been breached. Second, rebalancing is often done by bringing everything back precisely to the target, which may incur unnecessary trading costs and tax consequences.

Intelligent rebalancing requires trading off the cost to rebalance against total and active risk benefits to determine the optimal degree of rebalancing for each client. For example, bringing a client portfolio from a total risk level of 13% down to 12% while incurring 10% in taxes and trading costs will never make sense. The immediate cost is far more than the benefit from the risk mitigation. The right way to rebalance is conditional on the account’s registration for tax purposes and the strategy used for each client.

THE BOTTOM LINE

Market corrections are inevitable. Their timing and degree are also unknowable. The best way to contend with anxiety over market volatility is to invest time in determining the right risk objective, and then exercise patience and trust in the resiliency of the markets. It is not easy, but it is not complicated either.

Exercising discipline over emotions and trusting your Investment Advisor to manage your portfolio through rough waters will not only help you sleep better at night, it is also more likely to generate a more productive outcome than trying to forecast markets or react to them.

 

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