“Fear tends to manifest itself much more quickly than greed, so volatile markets tend to be on the darkside. In up markets, volatility tends to gradually decline.”
Learning to live with the new reality of volatility:
Volatility in the marketplace can be a demoralizing time for investors. Equities can lose a significant portion of their value in a matter of hours, adversely affecting the performance of their portfolio. Volatility can result from a plethora of various events, which are grouped into macro and micro economics. Macro events study the behavior of the economy as a whole, such as industries and a country’s GDP; whereas micro events study the actions of companies and individuals from within, including government taxes, regulation and supply and demand. It is imperative to understand volatility in the marketplace, to seek professional guidance when needed, and to have the discipline to stick to your personal investment strategy. This blog will focus on macro events; what they are and how they affect one’s investments.
To put it simply, macro events are not within one’s control. These events represent the totality of the overall, combined nationwide results of individuals and company performances that, once statistically accounted for, paint a clearer picture of the overall direction the economy is headed. The interpretation of these results will often lead big money managers to shift their market positions; and when they make a large dollar outflow from an investment, an individual invested in the same security can, in turn, lose value. This is why a sound, diversified strategy is paramount to preserve one’s portfolio value. Let’s take a look at how the current macro environment we are facing can affect one’s portfolio as 2018 comes to an end…
Trade War…
Through the imposition of tariffs by both the United States and China, the ripple effects can be felt in numerous ways all the way down the economic ladder. By substantially increasing taxes on goods imported from China to the US, companies are forced to pay much more for the materials used to produce products and/or services. As a result, the company will most likely pass these costs onto the consumer, which you may already be able to see in stores visited on a daily or monthly basis. These prices can increase marginally, perhaps an additional 12%, or even higher than that, depending on the goods purchased. It can be financially shrewd if you can identify which products have the higher increase, and avoid or substitute those products for something similar. Or, a company may not pass ALL of their increased costs to the consumer, and choose to absorb some of these costs into their earnings, ultimately having a negative effect on its level of profitability; which will drive the stock price down and, in turn, drive an investor’s portfolio value down.
Interest Rates & Inflation…
With the recent passage of the tax cuts, seemingly having a great impact - people and businesses get to pocket more of their annual earnings, however, it can negatively impact the economy as a whole. So, although the market sees a short-term bump in companies’ profits and a steady rise in stock price (and portfolio value), the Federal Reserve (Fed) has a responsibility to keep the economy from “overheating”, which occurs when buying power substantially exceeds the available supply. To combat inflation, the Fed will raise interest rates in order to slow the pace of growth, which will help to keep inflation from getting out of hand. For example, if you are searching for a new home these days, you may be able to see the effect higher interest rates have on the housing market. Also, the pressures put on the housing sector stifle the valuation of companies in the housing industry.
A higher interest rate also increases the cost of borrowing, i.e. credit card interest, home loans, and student loans. And that’s not all, higher rates cause the value of bonds to decrease and the yields to rise (interest that is paid), which can pull investors away from stocks into a less risky investment with an acceptable, guaranteed level of return; eliminating risk, which is always enticing for investors.
A Strong Dollar & Global Economies…
There is a downward trend among global equities, partially a result of collateral damage from the trade war. Emerging economies have had their growth stalled due to several factors, but do not despair, markets have their own natural economic cycles throughout history, where periods of high growth typically proceed periods of contraction. This downtrend appears to be on the economic horizon, so it is important to keep the bigger investing picture in mind. With that said, another economic speed bump is that a strong dollar will hurt American profits overseas. As other countries struggle to ensure a healthy rate of growth, Italy and Greece are struggling to keep their high debt levels under control, and those troubles have impacted other European markets. Currency exchange rates are important for investors to keep in mind, especially when investing in companies that have a large dependence on sales in foreign markets. When the US dollar is riding high, profits repatriated to the US are smaller than expected, which can drive the valuation of a company down...but the good news is that this has always been temporary (barring investment in a company with bad management), and a savvy investor can create a strategy to capitalize on this exposure.
Other factors that can affect movement within the markets include unemployment levels, wage increases/decreases, production levels, prices of goods manufactured, and political events (such as infrastructure spending, to more impactful events, such as war).
“You shouldn’t own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.”
I remember as if it were yesterday. On September 29, 2008, the Dow Jones careened; it fell 777.68 points in intra-day trading. What makes this so vicious is on October 9, 2007, the Dow hit its pre-recession high and closed at 14,164.53. By March 5, 2009, it had dipped more than 50% to 6,594.44. Incredible! The reason for this drop was that Congress failed to pass a bank bailout bill, which created a panic, resulting in a massive sell-off. At the time we hadn’t seen the market fall that severely since the “Great Depression,” during the Depression the market fell by 90%. However, it was over a 3 year period.
Back in 2016, I wrote a blog post called, “Volatility the New Reality.” If you take a look at the chart above, we can see that 5 of the most significant drops in history have taken place in 2018.
For many, this is downright terrifying. However, these drops are different from the ones we’ve experienced in the past. The previous decreases were driven initially by some micro indicator and eventually aggravated by a macro component. While these drops, when seen in our recent history, were inspired by a macro element, and don’t seem to reflect any one micro indicator. Therefore, we can conclude that the market may take huge dips with no lasting economic cause, which means that the volatility may play a more prominent role in the market than it did in the past.
“ ”Two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. ... We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
The answers for successfully dealing with volatility can be found within a few of LCM’s investment principles:
1. DISCIPLINE: Maintain perspective and long-term discipline. Investing can provoke strong emotions. In the face of market turmoil, some investors may find themselves making impulsive decisions or, conversely, becoming paralyzed, unable to implement an investment strategy or to rebalance a portfolio as needed. Discipline and perspective are the qualities that can help investors remain committed to their long-term investment programs through periods of market uncertainty. Because investing evokes emotion, even sophisticated investors should arm themselves with a long-term perspective and a disciplined approach. The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustifiable pessimism (which makes them too cheap). Abandoning a planned investment strategy can be costly, and research has shown that some of the most significant challenges are behavioral: the failure to rebalance, the allure of market timing, and the temptation to chase performance. Far more dependable than the markets is a program of steady saving. Making regular contributions to a portfolio, and increasing them over time, can have a surprisingly powerful impact on long-term results. After all, in the end, how your investments behave is much less important than how we behave.
2. GOALS: Create clear, appropriate investment goals. A proper investment goal should be measurable and attainable. Success should not depend upon out-sized investment returns, or upon impractical saving or spending requirements. The best way to work toward an investment goal is to start by defining it, take a level headed look at the means of getting there, and then create a detailed, specific plan. We believe that a stock is not just a ticker symbol; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price. Here at LCM, we are critical thinkers who take no Wall Street “fact” or statements from pundits on faith; we invest with patient confidence, taking steady advantage of opportunities that a volatile market presents.
3. BALANCE: Develop a suitable asset allocation using broadly diversified holdings. A sound investment strategy starts with an asset allocation appropriate for the portfolio’s objective. The allocation should be built upon reasonable expectations for risk and returns and should use diversified investments to avoid exposure to unnecessary risk. Asset allocation and diversification are potent tools for achieving an investment goal. A portfolio’s allocation among asset classes will determine a significant proportion of its return—and also the majority of its risk of volatility. Broad diversification reduces a portfolio’s exposure to specific risks while providing an opportunity to benefit from the markets’ current leaders. No matter how careful you are, the one risk no investor can eliminate is the risk of being wrong. Create a “margin of safety” by never overpaying, no matter how exciting an investment seems to be.
4. COST: Minimize cost. Markets are unpredictable. Costs are forever. The lower your costs, the greater your share of an investment’s return. Research suggests that lower-cost investments have tended to outperform higher-cost alternatives. To hold onto even more of your return, manage for tax efficiency. You can’t control the markets, but you can control the bite of costs and taxes. The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.
“No matter how great the talent or efforts, some things just take time. You can’t produce a baby in one month by getting nine women pregnant.””
We believe if you follow these four principles you will increase your chances of weathering these financial storms. It would be best if you avoided being emotional and fearful at all times because panic has brought down many economic systems as well as destroyed many lives. The opposite is true of patience, soberness and a disciplined approach to life and investments.
Authors: Marcus Turner, Pat McElya, Nicholas Ward
