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Question of the Week - February 16, 2016

Question of the Week - February 16, 2016

Guest Post - Tuesday, February 16, 2016

1. Why is the market reacting so violently this year?

The market correction so far in 2016 is the second in just a few months. Historically, it's not unreasonable to expect a -10% equity market downturn once every 12-18 months, but, until last fall, several years had passed since the last episode. So, aside from being overdue, volatility events have a nasty habit of clustering. So, just as periods of lower volatility tend to perpetuate for a while, so do periods of higher volatility.

This is a summary of some comments we made during the most recent monthly advisor meeting in regard to current conditions. If you weren't able to attend, here is a snapshot of some key points—laid out to balance a few dichotomies faced by investors today.

[-] What's Wrong [+] What's Right
Low oil/gas prices...from the perspective of the energy sector as U.S. economic growth and jobs engine. Low oil/gas prices...traditionally, low prices are a boon to business and household budgets.
Business spending/capex has been weak throughout this recovery. Manufacturing has been in contraction for several months. Some of this is related to the strong dollar, some related to low oil prices, among other factors. Consumer spending has been decent (as measured through sales of motor vehicles for one example, and some hope has been seen in housing, through higher sales prices).
A strong dollar has pressured exports. This is a key negative that has kept economic conditions tighter than the normally would be perhaps and has certainly affected S&P revenues. Conversely, a strong dollar/low inflation has aided imports. This is one case where the strong purchasing power of the dollar is helpful. Another positive is that the USD index has stalled out into rangebound movements since the sharp appreciation in 2014.
Growth is low, both in U.S. and abroad. There continue to be concerns over a hard landing in China, which would cause global growth rates to fall further. Currently, there appear to be lessened structural excesses/systematic leverage that led to the Great Recession and similar major downturns.
Fed policy uncertainty. The probability of rate increases in 2016 has decreased from 4 events to perhaps just one, but this remains data-dependent. Low rates overall remain stimulative, although the hint of another rate cut or even negative rates has confused markets.
Unemployment may not dramatically improve from here, being near theoretical levels of 'full employment'. Unemployment levels are very low, and could still fall further. There are some signs of wage gains sporadically.
Wider credit spreads have pressured high yield bond prices. If such spreads prove pervasive and sticky on broader level, could cause wider increases in credit costs. The biggest problems in high yield appear to be relegated to the problematic energy/materials sectors. Spread widening in other sectors could be overdone.
S&P stock 'earnings recession', with several quarters of poor results (led by the energy/materials sectors). Other 8 sectors (all but energy/materials) have grown EPS 5-10%. If oil stabilizes and/or recovers somewhat, might see positive overall growth.
Poor sentiment. From economic level, this always means a risk of a self-fulfilling pullback in spending by consumers and businesses. Poor sentiment. From a market standpoint, negativity is a positive contrarian market indicator—far preferable to over-exuberance.

2. Should I just move everything to cash until things calm down?

Probably not. We go through this exercise every so often. Intuitively, many investors realize the answer should be no, but often can't help themselves. It might be instructive to take a step back and unwind the various decisions being made when the urge to 'do something' becomes strong enough.

Taking investment action often feels better since it allows for a sense of a control over macro events that appear to be out of one's control. Individual investors are largely at the mercy of the broader market; however, the irony is that the market itself is an aggregation of all individual investors. Action done for the sake of taking action (without sound investment rationale) can often be unproductive at best and damaging at worst.

The 'experts' are prone to reaction as well. Economists and other market strategists can be smart people and forecasts are often well-grounded based on most recent data and events. This recency bias is often extrapolated to the future, but we know the future is usually unlike the past. Economic forecasts should also be taken with somewhat of a grain of salt, as the track record of forecasts is often poor and they're prone to revision on an almost continual basis. While markets have an embedded knowledge based on the universe of participants, they can take on a life of their own, just like a mob, and push to bullish and bearish emotional extremes. This is why these behavioral extremes, which can often accompany extremes in valuation, are often good inflection points for investors—albeit often in a contrary way (when it makes sense doing the opposite of what the crowd's doing). All investors need to be reminded of this every so often, as it is very easy to get caught up in day-to-day news and market dynamics/sentiment.

Back to the cash question. For one, moving to cash could be effective if all available investible assets were very expensive and forward-looking return expectations for the next several years fell accordingly. In that case, going to cash would be a contrary position, as, most likely, the crowd would still be optimistic after bidding up asset prices to high levels and expects them to rise further. If we flip this argument, it makes less intuitive sense—which would be selling assets after they've already declined in price and are now far cheaper. (This is self-serving, as our entire investment approach is based on this valuation-oriented concept, but it's hard to argue that it's not a rational way to view the investment world—many well-regarded 'classic' investment icons would no doubt agree.)

Assuming an investor makes a rash decision and sells after a market decline, a second important question arises: when does he/she re-enter the market? The risk is that the investor would sit in cash or an equivalent investment for far too long, only deciding to re-engage after 'feeling better' about things—whether that be economic news, an election, a stretch of green arrows on a screen, or some other catalyst. Market risk premiums are the price paid for uncertainty and volatility—you can't earn a return for nothing. So, of course, feeling better and re-entering investment markets means that he/she is already late to the game. If the investor makes such decisions often enough, long-term returns can be severely reduced. The famous 'Dalbar study', which looks back on actual investor vs. market returns shows us this very phenomenon, in fact—investor returns were about half of market returns during various periods. This may not seem like much difference over a year or two, but over an investment horizon of 20-plus years, the compounding can matter significantly in achieving financial goals. While no investment philosophy works perfectly in every cycle, consistency is a key for many successful strategies, and the goal is to increase your odds of success.

Read our Weekly Review for February 16, 2016.

Read the previous Question of the Week for January 25, 2016.

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