Diversifying Investments in High-Volatility Markets
I have been writing for several weeks now about my belief that we are in for an extended period of time of higher volatility than we have been accustomed to the last three years. If nothing else, the eventual tightening of monetary policy (vs. perpetual loosening) is bound to create elevated volatility levels relative to the quite compressed volatility that many years of zero percent interest rate policy has facilitated. The important thing to understand about volatility, as we have seen, is that it cuts BOTH ways. I have found that most clients only seem to mind it when the volatility is to the downside. With that said, I really like this week’s commentary and hope you will find it useful as you put the present market environment into perspective.
My top points of the week, noted with an asterisk (*).
1) Read the very first question/answer about “market timing”, moving in and out, catching dips and selling tops, etc., etc. Few things are more important for an investor than understanding the practical realities of what it means to be invested.
2) I believe low correlations between the investment asset classes you own is a very important thing to optimize the risk/reward nature of your portfolio. Sometimes correlations increase when you least want them to (2008, anyone?). But even when things are moving in a similar direction when you don’t want them to, that doesn’t mean they do so with the same magnitude. Trust the time-tested process and the benefits they create in your portfolio over time.
3) The oil and gas pipelines as manifested in the Master Limited Partnerships have rebounded dramatically from their market lows of a week or so ago. Why? Because their sell-off itself was utter folly.
4) Speaking of oil, the complexities of what is going on in the oil market are quite important. Oil prices themselves do not move markets higher or move markets lower (evidenced by the fact that we have seen every possible combination of relationship between oil prices and stock prices over the years). Right now gauging the fundamentals of the oil market is not easy as the Saudi and OPEC maneuvering is very distortive. What I am watching is where CAPEX1 spending may be affected.
5) Bull markets end at peak euphoria, not peak skepticism and fear.
* Do you ever feel a big market dip about to come, get a lot out or all out, and then come back in at way better prices?
No, but if God were to tell me when those big dips were coming AND when the big rebounds were coming right after the dips, I would do exactly that. Besides God, though, there is pretty much no one I would trust to guide such a behavior. Now, I do believe in taking weightings down when valuations are high, and elevating weightings when valuations are low, but the idea that I, or anyone else (besides the aforementioned deity) can know when to get out and when to get back in is demonstrably false. What we empirically know, with grave consequences to forgetting, is this: 80% of stock market gains come on just 20% of market days. The timing temptation is something that should not being touched. I am not opposed to the math of it; I am opposed to the idea that anyone can consistently do it.
What makes you think that companies will keep raising their dividends forever?
I don’t think “they” will. I merely think “ours” will. The fact of the matter is that dividend payout ratios in the S&P 500 are quite low and have plenty of room to expand, but the manner in which I manage money requires the pursuit of companies we believe are most culturally predisposed to such a thing (i.e., dividend increases are in their DNA). Companies generally grow dividends when earnings grow; they super charge dividend growth when BOTH earnings grow AND the percentage of earnings they pay out grow. The pursuit of this is not for the faint of heart.
What is the big advantage to a broad market sell-off?
The disadvantage is the correlations go up very high which means asset allocation (like the type practiced at The Bahnsen Group fails to be effective for a short while), but the big advantage is that, well, correlations went up very high (meaning, bottom-up stock pickers have a chance to add to positions or buy new positions of stocks that were improperly and indiscriminately bid down).
* So high correlations amongst individual stocks can be a good thing. What about high correlations amongst entirely different asset classes?
I have written dozens of times over the years about the merit of incorporating non-correlated asset classes into one’s portfolio construction. The idea is as simple as age-old diversification theories: By including risk premium asset classes into a portfolio that don’t necessarily move up or down for the same reason that other risk premium asset classes do, we can theoretically improve returns with a lower degree of volatility. From 2000-2002 we know that U.S. equity markets went through severe distress with the bursting of the tech/dotcom bubble, the aftermath of 9/11, and the minor 2002 economic recession. And yet, investors with exposure to REIT’s (real estate investment trusts), Commodities, Global Bonds, and even High Yield bonds did quite well in that period. However, we also know that in 2008 most asset classes became highly correlated to one another because the general global climate was an extreme version of “risk off”. Treasury bonds and Managed Futures did well, but, for the most part, correlations became very high and it was hard to find a place to hide. I don’t offer the doctrine of non-correlated asset classes as an infallible solution to the tail risk of stock markets; I simply suggest that the testimony of history is that it can be a very good idea to diversify in this manner. We are in a period of unprecedented low interest rates both here in the states and globally. This is, to me, indicative of higher correlations than otherwise would be. I want to use non-correlation as a weapon to mitigate volatility when I most need volatility mitigated (i.e., really bad times). It isn’t easy to do
Any other thoughts on correlation?
Asset prices in your portfolio may move in the same direction despite my efforts to produce non-correlation during times of distress. However, if one asset class moves down 20% in a given period and another moves down 5%, I would suggest that some benefit was derived from that asset allocation. I need to manage for the direction of asset prices, but also the magnitude of those movements (3).
What exactly has all of a sudden exacerbated the economic weakness in Europe, or at least exacerbated the market’s fear of European weakness?
I don’t know why the market has been as optimistic about Europe as it has been. Since the Euro zone began forcing European bond yields down in the summer of 2012, the entire European growth story has been predicated on rhetoric – the mere talk from the ruling elite that reform and structural financial improvement were coming. As economic weakness came to fruition in Germany last week, the market seemed to say, “Okay, enough talk.” I read a paper this week (1)saying what we need now is for Germany to realize that their fiscal austerity and aversion to QE is causing the problem. I strongly disagree. True economic growth is the need of the hour in Europe. It will not happen without honesty, accountability and fiscal management. The European weakness talk is catching on because all we have seen out of Europe is talk.
What would those who are bullish about Europe say is the basis for optimism?
I read a lot that pending actions from their central bank (all in one way or the other related to stimulating lending and borrowing) will help drive credit growth and economic activity. At the foundation of this belief is the idea that Europe’s problems are cyclical, not structural (sound familiar?). I have no doubt there will be an effect on European credit markets if, indeed, they go forward with aggressive purchases of asset-backed securities. Astute fixed income managers may even be able to profit from the next generation of European bond market gyrations. (We have several traditional and alternative strategies in this space.) But, as for the idea that mere monetary gamesmanship alone can solve a crisis of excessive debt and declining growth, we only need to look to Japan for over two decades to know that it is simply not true.
What are you getting at?
This applies to my entire equity philosophy, not just Europe: If one is functioning as a top-down investor (looking at whole markets, whole indices, whole countries) vs. the individual company fundamentals a bottom-up guy looks at, that investor BETTER see GROWTH in the country or market in which he’s investing. Where growth is, so will there be investor returns. Where there is no growth, or disappointing growth, investor returns will be disappointing, as well. I cannot buy the Europe or Japan bullish thesis because I do not see growth, short-term or beyond …
* Did you feel validated last week in your belief that the MLP sell-off was not rooted in fundamentals?
Let’s put it this way: Evaluating this energy sell-off from August 29 through October 14 shows a 15% drop in the price of oil, a 15% drop in the Alerian MLP index, and a 18% drop in the S&P energy index (2).In other words, energy stocks, MLPs, and oil prices were all treated exactly the same. This is silliness. As I often remind clients, pipelines care about commodity volumes not commodity prices. The long-term correlation between MLPs and crude oil is a paltry 0.4. (2).
Do you like the regional banks at these levels?
No, I don’t. I believe they are highly dependent upon a very unknown economic variable which is where interest rates are headed. Larger more diversified financial institutions also have exposure to interest rates. (Net, net, they prefer they be higher so as to generate greater net interest margin which has been practically non-existent for years.) But the larger firms have more operating leverage, more diverse revenue sources, and more control over costs. The regionals, to me, may very well benefit from a certain potential rate outcome but have much more downside risk to ongoing low rate surprises.
* Do you see lower oil prices as a cause of a weak economy or an effect of a weak economy?
At this point, with the current oil price weakness we are seeing, I see it as neither. Primarily, I see this as a Saudi vs. OPEC geopolitical issue likely to see stabilization in the coming months. However, the argument exists that should prices drop enough, it could cut into CAPEX1 spending which could cut into overall economic growth. This is, on the surface, a legitimate concern. The other side argues that whatever CAPEX reduction you get will be more than offset by the stimulation consumers and manufacturers get from lower oil costs. I think applying normal economic fundamental discussion is very tricky with oil because of the role geopolitical factors and OPEC manipulation play in its pricing. I promise you I am watching all data points very carefully.
* So when will we know that the big post-2008 bull market in stocks is over? Has this recent sell-off been the beginning of the end?
I am firmly in the camp that bull markets die on euphoric exhaustion – when there just isn’t any bullish sentiment left out there. All bull markets feature corrections and dips within them. This recent hiccup seems unlikely to me to be the end of the big bull market we have been in, but I base that purely on the lack of accompanying euphoric sentiment we always see when bull markets come to an end. I want my clients to know three things:
1) The exact short-term conclusion about this market action is totally unknowable.
2) The bigger-picture bull market we have been in will come to an end at some point, which will mean much larger declines in stock markets than we have seen in recent weeks.
3) We manage portfolios at the Bahnsen Group agnostic to #1, and aware of the reality of #2. We are not able to bypass the effects of #2 altogether. Rather, we use a specific approach to stock management to neuter much of the effects of bear markets, and to maintain client withdrawals throughout such periods. We use asset allocation, tactical tilts based on valuation, and the use of alternatives to mitigate the effects of – but not bypass altogether – large sweeping stock market drops.
What do you think about attempts to gauge this economic recovery or stock market or whatever in the context of past economic recovery timelines, etc.?
I think it is futile. Some recoveries have been short-lived. Some have been quite long. Each recovery has to be understood and evaluated on its own merits and particulars. If one recovery lasted 24 months and one lasted 120 months, trying to look at an “average” recovery time as anything relevant is quite dangerous. Averages don’t help much in the trenches. These things are tools of economists and analysts who don’t want to admit the fundamental truth about their craft: We don’t know what the future will hold.
Why is the U.S. dollar so strong even as we have run up a $18 trillion debt?
Our debt level is high; our debt level AS A PERCENTAGE OF GDP2 is much, much lower (than Japan or Europe). Always and forever, the issue is growth. We actually grow in America; that’s the key holding it all together. Take away the growth; it’s a different story.
Do oil prices predict where the stock market will go?
Oil prices serve as no predictor of stock prices, short- or long-term, whatsoever. Oil down; stocks up (the 1990’s). Oil up; stocks up (2009-2013); oil up; stocks down (2007); oil down; stocks down (2008). No correlation.
1CAPEX (Capital Expenditures)
Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to building a brand new factory. I would personally include technology upgrades in the definition of CAPEX, as well.
2Gross Domestic Product (GDP)
GDP is the monetary value, a benchmark measurement, of all the finished goods and services produced within a country’s borders in a specific time period – usually calculated on an annual basis. It’s commonly used as an indicator of the economic health of a country.
GDP = C + G + I + NX
“C” is equal to all private consumption, or consumer spending, in a nation’s economy
“G” is the sum of government spending
“I” is the sum of all the country’s businesses spending on capital
“NX” is the nation’s total net exports, calculated as total exports minus total imports.
QUOTE OF THE WEEK
“A stock dividend is something tangible. It is not an earnings projection; it’s something solid, in hand. A stock dividend is a true return on investment. Everything else is hope and speculation.”
— Richard Russell
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I will leave it there for the week. We have had a lot of action to absorb this month, and there is still a bit to go. Stay committed to a long-term and sensible investment plan, and remember the futility of trying to game these markets. The market has a nasty sense of humor and those who decided to “pause on the sidelines for a bit” a couple of weeks ago were given a grand total of 24 hours to see how painful of a decision that can be. Now they get to face the agony of coming back in knowing they messed up. The easiest way to avoid the hamster wheel of death for an investor is to never get on it to begin with.