Tis the week before Christmas,
And my time’s running out!
“I can get it together,”
(Said with a hint of doubt.)
So what is it about a campfire that we find so mesmerizing? The sense of community, the inherent danger of a destructive force, contained somewhat, for the enjoyment of those present? I don’t know. Maybe it’s just something to stare at while you figure out what to say next. Regardless, it makes for a great environment. I was afforded such an opportunity this last weekend, as a matter of fact. As part of his son’s birthday party, a friend invited the dads along to hang out by the fire while the kids ran around with flashlights. Who would have thought that running around in the woods, in the dark, would have been safer than sitting by a fire? Not me. But that’s what I get for thinking, I guess.
Adhering to campfire etiquette, I took a turn scouring the woods for firewood. Almost immediately, I happened upon one of those little trees which grows out of the base of a bigger tree. “Hmm,” I said aloud. And at that moment, my gut says, Dude, you can totally rip this thing down. Nonchalantly, I gave it a few cursory pulls to gauge the resistance. See, my gut offers, you got this! That’s it, I thought. This tree is mine! So after some serious pulling and heaving…snap…snap! The first snap was that of the tree finally giving up the ghost. The second was my ankle’s response to my torso rolling up on it. Two things were accomplished with that lapse in judgment: One, the tree was down - thank you very much. And two, there was no shortage of things to laugh about around the campfire. Here’s what I know to be true:
Your gut may not lie to you. But that doesn’t mean it’s always right.
For example, and more to the point, people are tempted to listen to their guts during market declines. And what do you think their guts tell them? Let’s listen:
“Ugh, look at what the market did today. You can’t take many more days like this.” [Then after another week of declines] “All right, what’s going on here? You need to do something about this. You can’t keep losing money. Maybe you should sell and go to cash for a while, you know, until things settle down.”
Let’s assume this is your gut talking. And who could blame you, right? It’s unsettling to watch your balance drop. So, after consulting with your gut, you feel you need to take action - so you sell. Then you watch and wait… and after some amount of time and a series of market increases, you figure it’s safe to get back in – so you buy. Sound familiar? Well, you’ve likely broken the first commandment of investing:
Thou shalt not sell low and buy high.
“So what would you have me do?” you ask, “just ride it out…do nothing?”
No. I would echo the sentiments of our Chief Investment Officer, Marshall Bolden:
“I think the best course is to evaluate what is driving, or thought to be driving, market movements, and then determine a prudent response. If there is fundamental deterioration in the economy, the markets have become overpriced versus long-term averages, or some similar factors exist, it may be wise to alter the investment strategy by reducing risk. However, an improving economy, low market valuations, etc., might mean that added risk is a wise option.”
At the time this post was written, one would characterize the economy as slowly growing and in a period of fundamental improvement. That being said, I’m not suggesting that you don’t need to make changes to your investment strategy, okay? I’m just stating there’s little wisdom in making wholesale strategy changes based on the day’s news cycle.
News cycles determine short-term market movements
while fundamentals lay the groundwork for long-term trends.
The real driver in your investment strategy should be the financial plan you’ve created. Your plan should have more influence on your strategy than the price of oil on Tuesday, the price of tea in China, China itself, and yes, maybe even more than your gut.
So, a week later, I’m still hobbling through my gut’s recommendation. I’ve been able to enjoy crutches, watch the purple accented aurora borealis dance upon my foot - all for a piece of wood that was too green to burn in the first place. Don’t be campfire discussion. Your gut wants what’s best for you, to be sure. But in my experience, at least, it doesn’t always know what that is. You and your gut need to find a financial advisor you both can trust and allow them a say in the matter. All of you will be glad you did.
Disclaimer: One tree and one ankle were hurt in the making of this blog post.
For our family, the day after Thanksgiving is a day of adventure. Mommy spent the day with her three sisters, leaving the four men free to roam the wild, uninhabited regions of north Atlanta. Since there are no such places, we opted for the Old Mill Park on the banks of Vickery Creek in historic Roswell. Founded in 1839, the Roswell Manufacturing Company used the mill to produce cotton and woolen supplies for the Confederate army. In 1864, Union soldiers destroyed the mill during the Atlanta campaign of the Civil War. Remnants of the mill have been preserved and surrounded by a wonderful outdoor nature center with hiking trails, covered bridges, and a man-made waterfall used to supply power to the mill. So, with the backdrop of Civil War history, I turn the boys loose.
This exploration began as most of ours do – with a spitting contest off a pedestrian bridge. Callahan took first prize with an effort leaving him just inches from the targeted brown trout. (Charles Henry’s attempt never made it past the railing and is likely still there.) As is often the case, the boys sought the path less traveled and left the pedestrian bridge for the banks of Vickery Creek. We walked over rock and limb, meandering our way to the base of the waterfall, where our “path” abruptly ended.
Our options were few.
Go back the way we came, or cross a network of pipes traversing the creek.
(The above is the view whence we came.)
Before I could address the pros and cons of our options, they opted for the pipe. Having had my share of adventure, I was fine with retracing our steps and finding the nearest bench. In the face overwhelming odds, I offered:
“If we turnaround, maybe we could search for some Civil War relics, huh?”
They would have none of it. Onward and upward.
William (12) first, followed by Nicholas (17), Callahan (9), me (old enough to know better), and Charles Henry (7) holding, no, strangling my hand from behind. Like a cat, William made the 25-yard crossing in no time. In between his hops, skips and jumps, Nicholas was filming the trek with his phone and took great pleasure in stopping at various points, forcing the rest of us to pause and maintain balance. Walking being too easy, Callahan preferred bear-crawling for a touch of panache in the face of peril. Charles Henry and I were less enthused and were moving into survival mode with every step. We were only half-way across.
As an Advisor, one of my responsibilities is to ensure that my clients understand the relationship between risk and return. With 2015’s fascination with volatility, you may have seen the effects on your retirement account. What’s that? You’ve not looked at it in a while? You’re not alone. Many opt for the “set it and forget it” approach. While that may work for some – depending on the allocation and the years in question – I don’t recommend it as a de facto approach to investment management. Nor would I recommend going to the doctor, checking it off your list, and not going back. You wouldn’t do that with your health, so why do it with what could be the single largest asset you’ll ever have? Talk with your advisor. Don’t have one? Find one.
Call us. We can help.
All five of us, thankfully, made it across the river that day. No one fell into the water or onto the rocks below. Interesting to note, the oldest (me) and the youngest (Charles Henry) seemed to have the greatest appreciation for the risks taken that day. Charles Henry, because he has no experience with such ramifications, and me, because I do.
Here’s the investor's take away from our "walk in the park":
Despite the above indictment, I consider myself a pretty good dad. But I guess there’s something in all of us that longs for risk, even if for a little, and even if we know better. More reason to surround yourself with wise counsel - which we would have had had she not already been out with her sisters. Nevertheless, on this day after Thanksgiving, we remained unscathed with our bellies full of adventure.
And thankful for both, we are.
October: [ok-toh-ber] n. from the Latin marketus volatilitus. Nope, totally made that up. Just a silly carryover from some science homework I’ve been helping my son with. Nothing to see here. But plenty to see below in this quarter’s addition of Ask a CFA with Marshall Bolden.
Marshall, put into perspective, please, the volatility we’re seeing in October.
There is a reason websites like Hotwire and Priceline have done so well, why retail stores are packed the day after Thanksgiving, or why ‘buy one get one free’ on certain cereals always works on me…most people enjoy feeling like they got a great bargain. I often find that this line of thinking does not carry over into investments in the stock market though. Now I certainly recognize that buying consumer products and investing have some differences, but the primary point is that, in both cases, lower prices usually means a better deal and higher satisfaction. I want to devote this update primarily to exploring this conundrum.
The Investment Update I wrote in January this year delved into market valuations – mainly the price/earnings or P/E ratio. At a basic level these valuation measures indicate the price we are paying for a stock or a group of stocks. As I noted in the January commentary, the long-term average P/E ratio of the S&P 500 index (large U.S. stocks) is around 15. So we could say the normal price is 15. If I know a pair of shoes normally sells for $75, I currently want or need those shoes, and I can buy them now for $50, I’m probably going to purchase them and feel good about doing so. And this thinking carries over to almost anything else I would purchase. But this gets a little fuzzy if we start talking stocks though.
Due to the recent pullback in the various stock markets I’m starting to hear questions about reducing risk, or reducing stock exposure. Let me be the first to say this is a question worth asking. I believe we have to explore why stocks have seen a pullback though before determining the appropriate action. If the declines are due to some fundamental factors (these are discussed further down), there may be good cause to consider reducing stock exposure. But if declines appear to be more a function of just the stock market doing its normal thing (volatility and periodic declines are normal) or of overreaction to some short-term fears or news, then we may be missing a bargain and acting contrary to what we would do on any other product. The appropriate action in this case may be to take advantage of the bargain, or to increase stock exposure.
So we need to look at the current price of the stock markets and what we believe has led to the recent declines. In evaluating various markets, it appears to me that current P/E ratios and other valuation measures have definitely improved over the last few months and are now slightly below their long-term average valuations. Sounds like there may be a sale going on. Reducing or eliminating stocks now may not be a good idea, unless we believe there is a fundamental reason or justification for stock markets to be declining.
If you listen to enough “experts” you can find hundreds of explanations for the recent declines, ranging from deflationary fears in the U.S., China’s economy slowing down, stagnant European growth, Russia’s intentions in Ukraine, ISIS in Syria and Iraq, Ebola fears, the Federal Reserve raising rates, etc. I will not address all these so that this commentary does not turn into small book. I will say that some of these issues could affect our view of the stock markets, but most of these (barring major changes) do not cause us much worry as to long-term stock market values.
I believe the important things on which to remain focused are the current and projected state of the U.S. economy, the expected growth of corporate earnings, and the current price of the stock markets. These are the fundamental issues that will primarily determine our view of stocks. I believe all three of these look favorable now. As stated above, the price (or P/E ratio) was looking a little high earlier in the year but now appears to be a little below average (or on sale). The U.S. economy has experienced growth the last several years – nothing spectacular, just consistent – and is projected to continue the trend or for the pace to even increase. Corporate earnings have also seen consistent growth for several years, and this is projected to remain the case the next couple years. So, considering these factors, we have a fairly optimistic outlook for U.S. stocks.
This is not to say the short term will not be volatile or that we won’t see any more losses. I’ve said in the last two Investment Updates that at some point stocks we would most likely see a 10% pullback or more and that volatility would increase. Markets do not rise forever in a straight line. There always has been and always will be disruptions, pullbacks, volatility, etc. This bull market had gone much longer than average without any disruption. The important things to remember are that long-term stocks have always gone up and that these more uncomfortable periods are often the best entry points, or the best times to increase risk because these are often the sales…those same sales we seek in every other area of life.
Let me draw one other real world comparison before discussing portfolio changes. Raise your hand if you rushed out to sale your house in 2008-2010 because the price of it was declining. Some people may have sold due to moving to another city, wanting more space, or some other reason, but few sold because the price was declining. That is because we know houses are long-term assets, we do not pay much attention to the value, and we expect that the price will rise in the long run. I believe it would be best to view stocks in a similar way. There are planning reasons to sell stocks when the price has dropped.
Excepting these, if we’re invested for the long term and have no changes in goals, what happens today or next week doesn’t make much of a difference; watching daily valuation changes is not important or productive. Your house is probably worth more now than it was 5 years ago. Your stock accounts (unless you sold in the 2008-2009 downturn) should easily be worth more than they were at the 2007 or 2008 peak. And I’m guessing if we hold steady through this turbulence, a few years down the road we’ll be much better off than we were when the markets peaked in the summer of 2014 and then fell from the highs.
Taking into account everything said above, it is our job to constantly evaluate what is happening in the markets and to adjust when we believe it is appropriate. This almost never means wholesale changes or jumping into cash, back into stocks, and so forth; I don’t know of any investors who have consistently succeeded at this type of market timing. Instead it means we are trying to find the values within different areas of the stock and bond markets and to take advantage of them. It also means we will make small shifts in exposure between stocks and bonds when this appears warranted.
When I see 10-15% declines, my normal course of action is to try to determine what caused this and then to determine if I can buy on sale. Both small company US stocks and MLPs have had such declines, and I’m beginning to get excited about the potential of buying on sale. International stocks are down over 15% in some cases, but I’m a little more cautious in this area because there are some fundamental issues that may justify the declines. The point here is that we look at many different areas on a case by case basis before deciding whether we think the falling values are justified or whether we think there is a chance to buy an asset on sale.
As we move forward, I think there is a good chance that we will increase our stock exposure, and that this will primarily involve increasing U.S. stock exposure with partially offsetting decreases to international stock exposure. On the bond side, we decreased risk with the changes made in July. I would anticipate keeping our bond risk about the same moving forward, but the overall bond allocations may decrease depending on how much exposure we add to U.S. stocks.
Marshall Bolden, CFA
Vice President, Chief Investment Officer
Today’s CFA: Marshall Bolden, CFA
Vice President & Chief Investment Officer
Q: So Marshall, describe for us the first quarter of 2014, and specifically address the topic of volatility.
A: The first quarter of 2014 was an interesting one from many perspectives. Stocks were volatile, commodities finally had a positive return, Russia and Ukraine grabbed plenty of headlines, and interest rates actually fell. The result of all of this was nearly positive returns across the board for the quarter; emerging market equities were the only major exception. Of these topics, I’m going to spend the most time discussing volatility in the stock market.
Stock Market Volatility
I believe the relatively calm U.S. equity markets of the last two years, paired with nice gains, have probably made a lot of investors more comfortable than we should be. As evidenced by the chart below, 2012 had volatility that was a little below average, and 2013 was one of the most placid years of the last 34. The grey bar is the S&P 500 return for each calendar year, and the red dot and number indicate the worst decline experienced during the year. So for 2013 the return was 30% while the largest pullback was 6%.
The chart indicates the average intra-year drop is 14.4%. Of the 34 years shown, 19 had a pullback of at least 10%. The 6% pullback of 2013 was very low; only two years (1993 & 1995) saw a maximum decline that was smaller. We’ve had two calm years now, but you can see there were other calm periods that lasted even longer (1991-1996 and 2004-2007).
|These facts were the most interesting nuggets I got from the chart. I point them out not to scare anyone but to set realistic expectations going forward. U.S. stocks cannot have much less volatility than we saw in 2013. And while the volatility could definitely remain low going forward there is really only one direction it can go…up.You may have noticed lately that stocks have seemed more volatile so far in 2014. As the chart shows, we’ve had a 6% pullback already this year, equaling last year’s worst. It would be my “educated” guess that volatility remains a little more elevated this year. Simply having such low volatility last year is the first reason. The other ties in the theme of last quarter’s commentary that U.S. stock valuations look a little high and the fact returns were so strong in 2013. I just believe we might have a little more back and forth this year.It would not shock me to have a 10-15% pullback this year. As we’ve already seen, this would just make 2014 a more “normal” year, and I don’t believe it would be anything to get concerned about. As long as corporate earnings continue to rise and the economy continues its slow growth, my position is that any decline of this magnitude would probably be a buying opportunity. We are definitely not going to attempt to time (get more conservative in anticipation of) any increased volatility or market pullback. There is no guarantee any larger pullbacks will occur this year, and we certainly don’t know when it will be if it happens. I just want everyone to be aware that volatility may increase going forward, that this would be normal and that market fundamentals still appear to be fairly strong.Russia & UkraineI’ve had a few questions concerning this situation lately and thought it would be good to share my thoughts. At this point the Crimean peninsula is most likely going to stay Russian. Russia has troops on the Ukraine border, Ukraine rebels are causing some issues, eastern Ukraine is pro-Russia, and civil war is a possibility. While humanitarian issues could certainly arise from all this, these issues alone should not cause much impact on the U.S. investment markets. The Russia/Ukraine issue would have to morph into a much larger issue to begin having a long-term economic impact in the U.S. and the rest of the non-European world. There is some potential for market or economic impact on Europe, and, as we currently have some European investments in select strategies, we will continue to monitor the situation and to evaluate any changes and their potential impact.
We did not make any changes to our Risk-Based or Genesis portfolios in the first quarter. Both the Market Opportunity portfolio and the CapSouth Value portfolio had a couple small changes. At this point I still do not anticipate any major changes in the short term to any of our portfolios. We are still positioned pretty neutrally in regard to our splits between stocks and bonds. Until some area of the market begins to either look cheap or overpriced, we will keep our current allocations pretty steady. I could still see us tweaking some things over the next few months, but these would just be minor adjustments.
In conclusion, I hope this commentary has been informative and worth your while. I generally get some feedback each quarter from readers and always love to hear your thoughts and/or questions that arise from these updates. So please feel free to contact me or someone else at CapSouth with any questions or feedback. And, as always, thanks for the trust you place in me and CapSouth; we’re honored to have the opportunity to work with you!
Marshall Bolden, CFA