Investing, by definition, is a long-term endeavor. But investing for the long-term means staying focused through periods of short-term volatility, and frequently negative news flow. As the old saying in media goes, “if it bleeds, it leads”. Big down days in the market are always accompanied by hyperbolic language in the financial media – markets “swoon”, “plunge”, “crash”! Now queue the gratuitous picture of the New York Stock exchange trader with his head in hands. One might think were on the brink of another Great Depression every time the Dow dropped a few hundred points.
Headlines like “Wall Street plunges as Treasury yields continue to climb” can, at minimum cause an innate stress signal. Compound these headlines over a number of media formats in a given day, and add a string of down days and one may quickly think their best move is to sell. But these headlines are so commonplace that they amount mostly to noise. There is always something to worry about. The aforementioned headline was from September 28 – a few weeks later and markets have recovered all of that one day “plunge”.
None of this is to say that investors shouldn’t think about risk, or that every stock market decline quickly recovers. Markets do go through bear markets – multi-quarter or multi year periods where the general direction of the market is down. But it is critical to separate pro-active and prudent risk management, from reactive risk management. Trying to predict the market’s next move based on “noisy” headlines, is reactive and unlikely to yield the desired outcome. Simply put, separating signal – real actionable information about market direction – from all of the market noise is akin to finding a “needle in a haystack”.
“But There is So Much to Worry About Right Now”
A short list of list of current market worries includes a prospective global energy crisis, a pickup in inflation, the expectation of Fed tightening in November, high valuation levels, myriad geopolitical concerns, a potential Chinese property market implosion, and the uncertainty surrounding the ongoing Covid19 pandemic. And those are just the ones that quickly come to mind. Time to sell right? Not exactly. Nearly every year of market history has a similar list of worries.
Take 2012 for example. In hindsight, most investors probably don’t remember 2012 as a particularly risky time to invest in stocks. It was a few years past the great recession. The economy was slowly gaining steam. Valuations were generally reasonable. But the list of investor concerns in 2012 was long: the Eurozone debt crisis, Fed tightening, the Greek debt restructuring, slowing growth in China, fiscal cliff fears, and a lowered IMF global growth outlook. Some of those worries sound familiar, others were unique to 2012. But none provided any great signal as to the future direction of the market.
But to the 2012 investor, without the benefit of a crystal ball – those worries felt almost existential. Add that list of worries to the sideways pattern of market returns 2012 investors had experienced over the previous 15 years (Exhibit A), and it seemed like a very uncertain and risky time to invest. In hindsight, investing money in the S&P 500 at any day of 2012, even at the year’s highest market price, would have yielded excellent annualized returns 9+ years on (Exhibit B).
Exhibit A: 15 Year S&P Returns As of September 30, 2012
Exhibit B: 25 Year Chart of S&P 500 As of September 30, 2021
*Source for Exhibits A & B: Compustat, FactSet, Federal Reserve, Standard & Poor’s, J.P. Morgan Asset Management.
Pro-Active Risk Management
The problem with market “noise”, is not that it highlights risks. Every risk we’ve described above is real – and could lead to a market correction or bear market. But when an investors extrapolates these risks in to a rigid prediction about the future they have moved from investor to speculator. Ironically this may increase their risk over time since the sheer volume and consistency of market “noise” will always give them a reason to sell. This attitude will lead to a heavily traded portfolio that whipsaws between selling scary headlines and then buying back in when the dust settles. Long-term compounding of returns will likely be low (or even negative) and inflation will likely erode the investors purchasing power.
Instead of prognosticating about things we cannot control, we recommend (and follow) an approach that focuses on what we can control:
- What to Buy: First, focus on an appropriate asset allocation for your objectives and risk tolerance. Most investors should not be 100% invested in stocks at all times. Younger, more aggressive investors, those with high risk capacities and/or those with a natural comfort with volatility may want to only invest in stocks for the higher return potential. But the first step to avoiding the full brunt of a bear market is to not be fully exposed to the market in the first place. Of course this comes with a trade-off – i.e. lower compound returns over the long-term compared with a fully invested stock portfolio. But if a bear market forces one to make a timing error and sell during the nadir of a bear market – then those higher returns will never come to fruition.
- The Price to Pay: The price you pay determines your return. Pay too high a price for any asset and your future returns will suffer. We seek to pay prices that make economic sense, and to avoid investing in situations where there may be a high likelihood of long-term capital impairment.
- When to Sell: Rather than sell on news, or a big prediction we generally sell under one of the following conditions: 1) We identify a more favorably priced asset and need to raise cash to fund the purchase, 2) when a holding has had a negative fundamental change and our original investment thesis is no longer valid, or 3) general rebalancing where we sell assets that have appreciated and buy those that have declined or stagnated to bring the portfolio back in line with its long-term asset allocation strategy.
- How to Behave when Markets Sour: Understanding market history may not help predict the future, but it can help investors maintain composure during difficult market environments. Since 1981 the S&P 500 has experienced average intra-year drops of -14.3%, with the largest intra-year decline of 49% in 2008. Corrections are commonplace, and bear markets are a normal and healthy part of the capital markets. Bear markets wash away excesses and irrational enthusiasm built up during the previous cycle, and provide opportunities for new capital to be put to work at attractive prices. By viewing the silver lining in difficult markets, we seek to maintain a steady hand, and ultimately take advantage of the opportunities these markets create.
Q3 Review and Market Outlook
Year-to-date through 9/30/21
- Domestic stocks (S&P 500) increased 15.9%
- Developed international stocks (EAFE) increased 8.4%
- Emerging market stocks (EM) declined 1.3%
- Bonds (Bar Cap Aggregate Index) declined 1.6%
- Commodities increased 27.1%
- Gold decreased 7.8%
We have updated our asset class return chart below.
Investors today are paying 20x earnings to own shares of the Large-Cap stocks in the S&P 500. However Small and Mid-Cap companies, those with market values below $10 billion, have seen their earnings multiples contract in recent months to 16x and 17x earnings respectively. While the prices of these stocks have mostly moved sideways since April, the lower multiples have come from an improvement in overall earnings. This is the good kind of multiple compression as fundamentals are outperforming price. In short, if the price you pay determines your return, better relative value can be found today in smaller domestic companies. We have been slowly incorporating a larger exposure to these in asset allocation oriented portfolios, and plan to continue to increase exposure here.
Likewise, whereas the “growthiest” stocks have outperformed the broader market index over the last ten years, value oriented stocks have languished. Growth stocks tend to trade at higher multiples naturally due to higher earnings and profitability expectations. But in recent years that spread of performance between growth and value stocks has reached extreme levels. We think this extreme divergence will correct itself over time, and that the price investors are paying today for value stocks provides them greater future return potential than pricier growth stocks. While we believe a well balanced portfolio should have exposure to both of these broad categories, we are currently finding more opportunity in the value sector of the market, and have tilted portfolio exposure in this direction.
For clients with allocations to bonds, we continue to take a safety first approach. Yields provided on lower quality debt just do not offer enough return to compensate us for the risks associated with this kind of debt. Some in this space argue that because defaults are expected to remain low that investors should just invest in these assets in order to get a marginally higher return. But this makes a big assumption about both the pace of defaults and the investors ability to get out “just in time”. This is a game of musical chairs we would prefer not to play.
Instead we are investing fixed income allocations primarily in higher quality and shorter-duration bond funds and ETFs – including both corporate and government bonds. We also continue to hold a sizeable fixed income weighting in Unconstrained bond strategies. These funds allow the manager to “go anywhere” in search of return in the fixed income market. Our preferred vehicle in this space continues to hold a sizeable cash balance, but we expect this strategy to be able to take advantage of dislocations in the bond market when and if they should occur. Finally, for accredited investors, we continue to recommend investments in private real estate lending vehicles that pay monthly distributions, and are backed by real collateral.
Individual accounts will vary based on a client’s stated investment objectives, risk tolerance and time frame. We manage several different strategies, so not every client will have exposure to the securities, asset classes or investment strategies described above. In addition to growth and/or income oriented asset allocation strategies, we also manage more concentrated equity portfolios that generally carry a higher degree of risk and volatility. Let us know if you want to discuss your specific portfolio strategy in greater detail.
Should you have any questions regarding your investment account(s) and personal financial plans, or if there have been any recent changes to your investment and/or retirement objectives, please do not hesitate to contact our office to speak with one of us at your convenience. We can also provide you with a current copy of our SEC Form ADV Part 2, at your request.
As always, we thank you for entrusting AMM to help you achieve your investment and retirement objectives.
Your Portfolio Management Team
