Everything You Need to Know About Market Volatility
Investors hoping for subdued volatility last week did not get what they were hoping for, but perhaps the volatility was more likable than three weeks ago. I talk a lot about volatility expectations in the year or so to come in this commentary. This summer has been quite interesting with the huge June rally, the big late July sell-off, and now up-and-down bouncing around in August. I hope clients can see the wisdom of our investment methodology in this type of environment. I cover a fair amount of ground but I think this commentary is readable and comprehensible. I am here to answer questions any time, and I continue to work more than you would believe if I told you at properly positioning client capital. Off we go…
My top points of the week, noted with an asterisk (*).
- Given Europe’s various lingering debt cycle concerns and weak economic data out of Germany (which has been Europe’s economic ballast), I fail to see any buying opportunities.
- There has not been a 10% correction in the S&P 500 since the fall of 2011 (3). Is this dramatic? In the 1990s the S&P went seven years without a 10% correction. Look, I have no reason to believe we will not have a 10% downswing due to short-term sentiment, but timing it or predicting it is a foolish endeavor.
- When sentiments and fundamentals are at polar opposites, it’s typically bad time to follow the crowd. I look for opportunities like this to make contrarian plays.
- The recent market volatility is attributable to more than just geopolitical matters. I believe the market’s anticipation of a decreased morphine supply from the Fed is creating higher volatility.
- Cash flow is king. As investors, our primary purpose with our portfolios is generating higher income over the long term. Then, it is a matter of what strategy will help us achieve this.
What are the actionable investment themes out of the Russia/Ukraine tensions?
I have had a virtually 0% weighting in Europe for quite some time as long-time readers and clients know, and that decision long preceded the current unknowns in Russia/Ukraine. However, as further reinforcement of that strategic decision, I will say that Europe is the most economically vulnerable should this situation escalate. They are Russia’s primary trading partner and primary source of energy. Sometimes, when you cut off someone as a provider of things you buy, you also cut off someone as a shopper of things you sell.
Thoughts on the status of Europe’s stock markets?
I don’t think much about Portugal’s recent 30% stock market drop or Greece’s recent 23% market drop, but Italy’s 13% market drop and especially Germany’s 10.5% market drop (1) are big news.
* So if an encouraging resolution were to unfold in the coming days or weeks regarding Russia/Ukraine, would you become more bullish on Europe?
No, not at this time. My fundamental issues for rejecting the European recovery thesis that had become so common in various analyst circles the last couple of years is that it is a flawed thesis. (How’s that for profound?) The data is not good in Europe, and various debt cycle disasters remain for the majority of the Eurozone countries. Germany is the heart and soul of the European recovery, and even Germany has seen a 3.3% drop in factory orders last month, a flat manufacturing index for three straight months, a flat industrial production last month, and extremely weak retail and auto sales for two consecutive months (2).With a 10-year bond yield of 1.06%, I would say the market is not casting a very high vote on Germany’s economic strength. GDP growth could possibly register a negative number in Q2 and it certainly is for many of Germany’s neighboring countries. The Euro has declined in the last month or so relative to the U.S. dollar (and frankly should have a lot more room to go in this regard) making dollar-denominated investments in Europe even less attractive. There are just a lot of structural problems there and I am afraid much of the common “wisdom” about Mario Draghi breathing reasons for bullishness into European markets is being exposed.
We’re only half-way through the third quarter, but what have been the best and worst performing asset classes so far this quarter?
By far the worst have been European stocks, U.S. small cap stocks, and High Yield bonds. The strongest have been Emerging Markets equities and Municipal Bonds.
* Do you believe we are due for a 10% correction in the S&P 500?
It isn’t a matter of whether or not we are “due” for one; sentiment drives markets in the short term and fundamentals (read: earnings) drive markets in the long term. Corrections of 10% happen at times either due to sentiment (short term) or fundamentals (long term). Neither sentiment nor fundamentals have created a 10% correction in the S&P 500 for the last 1,040 days (since the fall of 2011 to be precise). This is the fifth longest time period without a 10% correction in the history of the S&P 500. (The “fifth” longest … hmm … That doesn’t seem so dramatic, does it?) In the 1990’s the S&P 500 went seven years without a 10% correction. The best thing I can say is that we have had 20 occurrences since World War II of a correction between 10% and 20% (3).(also not too common when you consider World War II ended nearly 70 years ago), and I have no reason to believe we will not have a 21st occurrence. But timing it, predicting it, forecasting it, etc. are foolish endeavors. I cannot gauge what sentiment will do in the short term (nor should I try), and as for longer term fundamental analysis, corrections are but a blip on the chart of our final destination.
Any contrarian plays coming up?
Not just yet. But I will say this: Since I laid off the vast majority of my high yield exposure, spreads1 have widened in the high yield bond space from less than 350 basis points to about 425 basis points. The asset class has declined a couple percentage points in value. And now I see investors have pulled money out for four consecutive weeks … Could a re-entry into a high yield become a contrarian play in the near future? Potentially, yes. But not yet. That space had way too much froth on it and I need to see some better fundamental valuations before re-entering.
* And a “contrarian” play is ?
This is one of my most important investing principles. A contrarian investment thesis is nothing more than something that is “contrary” to a current, popular sentiment. When a lot of money is jubilantly flowing into a given asset class, we believe it may very well be a smart time to exit. When a lot of money is exiting a given asset class, we believe it may very well be a smart time to enter. Contrarianism is an investment ideology rooted in two empirical facts: 1) Sentiment and Fundamentals are very often at polar opposites of one another; 2) Following the crowd has been a very, very poor investment philosophy for decade upon decade.
Are you souring at all on the MLP space (Master Limited Partnerships)?
Most definitely not. The 5% drop in MLP values from early July through early-August produced a lower entry point than I had in late June as a buyer of MLPs. I, therefore, see the recent short term noise as a good thing, not a bad thing. (Remember, “buy low, sell high”?) The space had been up over 16% going into July, and remains up over 100% over the last five years. However, in this case, the 100% five-year price appreciation is fully justifiable given the fact that the income distribution from the underlying MLPs has ALSO appreciated over 100% in that time frame. An asset class that increases the income it gives off should expect price appreciation as a result – if not immediately, then eventually. My enthusiasm for the MLP structure, the MLP business model, and the MLP economic thesis (when tied to pipelines or other such aspects of U.S. oil and gas infrastructure) is very high.
What is the historical precedent to which you refer about the crowd seemingly missing the boat over and over again?
Email me if you are interested, but I came across a chart this week from Richard Bernstein Advisors LLC (4)(Richard has long been a favorite analyst of mine) showing the annual returns over the last 20 years of over 40 different asset classes, and contrasting that to the annual return of the average investor (measured by Dalbar in a robust study of mutual fund purchases, redemptions, etc.). Out of 40+ asset classes, the ONLY two asset classes that the average investor beat were emerging Asian stocks and Japanese stocks. Even CASH outperformed the average investor! How could an average investor who is invested in bits and pieces of these other 40 asset classes himself or herself actually underperform the very investments he or she is invested in? The only mathematical explanation is the immutable tendency for investors to buy what is overvalued and sell what is undervalued. This chart is enough to get me out of bed each morning for years and years to come.
Do you believe there will be a different paradigm for home ownership in the next generation than there was in the last one?
I certainly pray so, yes. And besides believing there ought to be, I do actually believe there will be, as well. This outlook is not based on a particular perspective on residential home prices going higher or lower or being a good or bad investment. Those issues are secondary to me. I have written for YEARS that a primary residence is, above all else, a place to reside. (Clever, huh?) I would expect the price of that home to increase over long periods of time to the extent that inflation and wages grow. Large increases in residential price appreciation ABOVE AND BEYOND wage growth and inflation growth generally tend to be short-lived. From a secular economic standpoint, I do believe the younger generation faces a whole different environment than those ages 25-35 did 10 years ago, 20 years ago, and 30 years ago. New household formation is simply not going to be what it was, and economic barriers to purchasing a first-time home (loan qualification, down payment savings, and student loan debt) are significant. Is this bullish or bearish for residential real estate prices? It is neither. EVERY market is different. Every dynamic vacillates. Interest rates play a huge role and we know how volatile they are. Future property tax dynamics are unknown. It is a complicated issue. I see no economic sustainability in the “quick buck” culture of home-flipping, so you don’t see me write about that very often. I am generally quite favorable on the idea of using residential real estate as a growing income play (in other words, I think the renters are here to stay), though this requires attractive entry points and good management. But do I think someone should be buying their primary residence as an “investment”? Only if that “investment” is in the place they live their lives and raise their families … Now THAT is an investment I can believe in!
* Do you think recent market volatility is merely a byproduct of uncertainty in geopolitical matters?
No, I actually do not. I think Russia/Ukraine have been a factor and to a lesser degree Iraq/ISIS and to a lesser degree than that Israel/Gaza, but primarily I believe what has taken place lately is mere foreshadowing of an increased volatility environment I believe we will find ourselves in for months or years to come. This is not a negative thing – the markets (and her investors) have enjoyed a free ride of low-to-no volatility for too long, and the Fed’s intervention in markets has been disruptive, disorienting, and now, ineffective. I am on record as saying that I do not believe the Fed will begin raising interest rates earlier than forecasted, but I also must tell my clients that the market’s anticipation of a decreased morphine supply from the Fed will create higher volatility. It is an inevitable consequence of unwinding five years of zero-interest-rate-policy. My prescription for this anticipated elevated volatility is rather simple: Fortitude combined with Dividend Growth Equities. But fortitude is easier to talk about than exhibit, and that is what you will have me for along the way.
* If I am only concerned with my portfolio going higher over the long term, and not caught up in short term fluctuations, am I on the right track?
I would nuance that a little bit simply to say, “I am concerned with my portfolio growing the income it can create higher over the long term”, but I know what you mean, and you know what I mean. The reason why it is not exactly semantics is because part of my argument is that the ONLY thing any investor cares about is actually income (or cash flow). We may THINK we simply want the value to be higher, but the only reason we want it to be higher is because we plan to sell it and use the cash for something (which is called “income”). Investors don’t care if they get to buy the things they want to buy in the future with cash that came from a profitable sale of an investment or a dividend from an investment. Cash is cash. But once we agree that the objective is the same (future ability for cash flow), then it is a matter of what strategy will best create it. I’ll argue for my growth-of-dividend strategy over competing strategies with passion and conviction.
1 Credit Spreads
A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. For example, if the 10-year Treasury note is trading at a yield of 3% and a 10-year corporate bond is trading at a yield of 5%, the corporate bond is said to offer a 200-basis-point spread over the Treasury.
Widening credit spreads indicate growing concern about the ability of borrowers to service their debt. Narrowing credit spreads indicate improving creditworthiness.
QUOTE OF THE WEEK
“Eventually everyone sits down to a banquet of consequences.”
– Ralph Waldo Emerson
I will leave it there for the week. It has been an interesting August so far with some big moves down and big moves up and, as I wrote a few paragraphs up from this one, such volatility may be more normal in the next 12 months than we may be thinking. I remain cautious but exposed, invested but defensive, optimistic but risk-aware. Balance and prudence are timeless principles.