CapSouth Investment Update
It has certainly been an interesting couple months for the equity markets. At the market close on August 25th the S&P 500 Index had declined 12.4% from its high point earlier in 2015. Over the following month it experienced some small gains initially only to end up retesting the lows on September 28th. From that point to now there has been a fairly persistent move up so that the S&P 500 is once again within striking range of its high point. Given this recent action, I want to review several items I’ve mentioned previously and then touch on the investment changes we made early in October.
As I wrote in the August 24th commentary, the volatility we’ve seen recently is certainly uncomfortable, and I think the rapidity of the pullback, occurring primarily over a one week period in August, added to the consternation. As was also noted the average pullback in any given year since 1980 has been 14.2%, so this recent decline of 12.4% from the earlier high point has been in line with the average. Needless to say, no one likes volatility and market declines, but I believe it’s important to keep emphasizing that this is a normal part of investing in the equity markets. We would all prefer the consistently rising markets, characterized by low volatility and small pullbacks like we experienced in 2013 and 2014, but these periods are just not normal...they are the exception to the rule.
Hopefully after reading the August 24 commentary most of you held the course, or didn’t reduce risk, so that you received the benefit of gains experienced since then. I can’t say with any level of certainty if the gains will last going forward, at least in the short term, but I can continue to be certain that long term stocks will almost certainly outperform bonds and cash. In exchange for this outperformance, stocks will most likely be much more volatile than bonds and will certainly be more volatile than cash. I have not found any investment yet that offers high returns and little to no risk or volatility. Therefore I’ll once again state that if your investment time frame is 5-10 years or more, you’ll most likely come out ahead by having a higher stock exposure, but if you have a shorter time frame the risks inherent to the stock markets should probably lead you to a more conservative, bond oriented portfolio.
This leads me back to another topic I’ve delved into previously. The greatest tool that you can have in place when dealing with investing and the financial markets is a long term plan that is based on your specific financial goals, dreams, and circumstances. The plan and progress toward meeting the various items in it then become the focus. Of course you should check the progress periodically and make adjustments when necessary, but any such adjustments should be done in light of the long term plan and never as a result of emotions caused by what the market is doing. Usually having a plan in place allows for more peace regarding market movements and whatever bad news the media is focused on that week, and therefore reduces emotional stress and decision making.
I’m rehashing most of this because I believe these beliefs and fundamental principles are especially vital in times of market drops; these are the times people feel the most urge to act. I’ve been around through several downturns now, and I know through experience that the urge to act normally means selling once the market has dropped and buying after its run up for a while – selling low and buying high. It is nearly impossible to earn an acceptable long term result doing this. I saw some statistics recently from JP Morgan that speak to this, and they’re pretty scary. They estimated that over the previous 20 years the average investor had a return of 2.5% per year. During this same time period the S&P 500 and a 60/40 stock/bond portfolio averaged 9.9% and 8.7% respectively. A boring and fairly conservative high quality bond index (the Barclays Capital U.S. Aggregate Bond Index) returned 6.2% annually. I could dig into a long interpretation of this, but I think the summary would be better – the actions of most investors are harming their long term
results. The numbers (although estimates) show this clearly, and the theories of Behavioral Finance that I’ve previously touched on speak to this being the common result.
I can imagine what some may be thinking at this point – “Are you telling me everyone should just ignore all the market movements completely...never make any changes or adjustments?” Not exactly, although the JP Morgan statistics above would indicate that is better than what normally happens, and I can relate many success stories of people who have set a prudent investment strategy in their 401k or retirement plan, periodically rebalanced, not payed much attention to account value changes, and ended up with some nice retirement assets! As I stated in the August commentary, I think the best course is to evaluate what is driving, or thought to be driving, market movements, and then to determine a prudent response. This should be done by or with the help of someone well versed in investing. 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 very wise to alter the investment strategy by reducing risk. An improving economy, low market valuations, etc. might mean that added risk is a wise option. Also, for those who have a long term plan in place, personal changes can often result in a need to change investments. So I’m all for monitoring and making changes, the changes just need to be based on solid reasoning.
Now I’ll move into what we’ve done given the recent market turmoil. I started by looking at all the things just mentioned. It’s my belief that the fundamentals underlying the economy continue to be sound and fairly stable. We could spend a lot of time discussing this and arguing about various points, but overall the economy has been in a period of slow growth and fundamental improvement. When the stock markets pulled back in August, many of them became more in line or even below their longer term average valuations. As I’ve already stated, we have no idea what the market will do over the next several months or even the next year, but given a steadily growing economy, fair to below average stock market valuations, and growing corporate earnings, we felt the prudent move was to slightly increase risk. So in early October we increased our equity exposure in many of the portfolios; this was primarily accomplished by adding to large, U.S. company stock. As the markets continually change in the future, this is the same process we’ll follow. There is no doubt that sometimes I’ll miss on an evaluation or misread the signs, but if we follow this prudent process, I believe that long term we’ll move the correct direction more times than not and will be rewarded with solid results.
Once again I hope this has been beneficial in helping to relate how we think and what we believe at CapSouth. As always I welcome the opportunity to answer any questions or issues you may have regarding our thoughts so feel free to call or send me an email if something is unclear or you just don’t agree!
Marshall Bolden, CFA
Vice President, Chief Investment Officer