Preparing for Stormy Seas
The last 5 ½ years have been an extraordinary time to be an investor. Rebounding off of lows in early 2009, global equity markets have delivered very strong returns… most equity asset classes have more than doubled over that time. Moreover, equity markets have been very placid, especially over the last few years, which hasn’t seen a single downturn in the S&P 500 greater than 10%. (To give you a sense of how unusual this is, historically the markets often see a 10% downturn once a year!) We have the Federal Reserve and its program of quantitative easing to thank for these calm seas… by keeping interest rates on cash and bonds very low, the Fed has pushed investors into equities and mitigated the normal downward pressure that builds-up in equities over time.
The Fed’s quantitative easing program is now over and interest rate increases are on the horizon, which will, on the margin, drain some of the demand for equities. Moreover, after over five years of strong returns, segments of both the equity and bond markets appear expensive to us. Consequently, as part of our bi-annual evaluation of capital markets, we’ve come to the conclusion that investors should expect less return and more volatility from their investment portfolios for the foreseeable future.
...investors should expect less return and more volatility from their investment portfolios for the foreseeable future.
When risk assets (e.g., stocks and bonds) become too expensive there are two ways for the market to correct the problem. First, the market can experience a pullback until such time that assets are once again at a fair value1. Alternatively, valuations can remain constant and the companies/securities that today are overpriced can “grow into their valuations” over time by increasing earnings. Both scenarios pose challenges for investors and, going forward, we expect both to occur, which is why we are projecting increased volatility.
Indeed, we have seen volatility pick up late this year. Most recently, we saw a 9% decline in the S&P 500 this fall – just shy of an official “correction” – before the market continued marching to new highs in November. The rebound reflects continued improvements in the US economy and developments in Japan and the EU, where policymakers are embarking on aggressive programs to stave off deflation, similar to the quantitative easing program in the US.
We’re troubled, though, by the fact that, in some equity markets – most notably US large and small companies – valuations appear increasingly stretched beyond what fundamentals suggest is reasonable. Certainly, equities have momentum now, but we are not momentum investors and, frankly, we believe that such investors often exhibit a herding mentality that can result in dramatic underperformance when markets correct. Instead, we are value investors, meaning we seek assets that are attractively priced, ideally in both absolute and relative terms. Because we are value investors in a world of pricey assets we are not positioning our client portfolios with the intent of grasping for every last dollar of potential return. Instead, while we are suggesting clients remain fully invested, we have become more defensive compared to our last evaluation of investment portfolios in 2011.
...we are value investors, meaning we seek assets that are attractively priced...
We are in the middle of conversations with all of our clients about updating their investment portfolios for the evolving investment environment, and will soon release an Insight article dedicated to the topic.
Volatility Gone Viral!
In an environment with stretched valuations, markets become more vulnerable to shocks, such as disappointing earnings, natural disasters and geopolitical events. That occurs because markets that are “priced for perfection” cannot absorb undesirable events. To borrow a phrase from Benjamin Graham2, at today’s market prices, there is a reduced “margin of safety” to absorb bad news, resulting in volatility when things inevitably go awry.
This is precisely what we experienced earlier this fall. The vulnerability of the market was exposed by a succession of negative events, including the potential for a third European recession in five years; China’s slowdown foreboding contagion across emerging and developed economies; the uncertain and untested ability of the U.S. economy to anchor the global economy; continued unrest in the Middle East elevated by the actions of ISIS; heightened concern over the conflict between Russia and Ukraine; and growing anxiety that the Ebola epidemic in west Africa might become a global pandemic.
Chart 1: VIX Volatility Index
The confluence of an expensive market combined with geopolitical concerns caused an upward spike in volatility across most asset classes. In fact, as shown in Chart 1, the VIX volatility index3 more than doubled this fall. It quickly declined again to a level 40% below its long-term average. We have been advising clients to brace themselves for oscillating periods of higher and lower volatility and to not become overly elated with “good volatility” or overly concerned about “bad volatility.”
...the VIX volatility index more than doubled this fall. It quickly declined again to a level 40% below its long-term average.
We believe that markets are generally efficient, which is to say that prices usually reflect all available information; consequently, we pursue a “benchmark neutral”4 investment strategy when markets are trading within their normal valuation ranges. In other words, if we don’t have clear and convincing reasons to adjust a portfolio, then the smartest thing we can do is to remain both patient and globally diversified across all asset classes.
As we’ll describe further in the upcoming Insight on our updated capital market expectations, we believe there are currently some clear and convincing reasons to make some portfolio adjustments, both at the asset allocation level (where we’re encouraging clients to eliminate or reduce portfolio leverage, add or increase fixed income exposure, reduce exposure to US small equities and increase exposure to international equities) and at the manager level (where we’re increasing exposure to “quality” equities – see sidebar).
Collectively, we believe these steps will help our clients become better prepared to weather a lower expected return environment.
...we are value investors in a world of pricey assets... we have become more defensive compared to our last evaluation of investment portfolios...
Managing Risk with “Quality”
The primary way to manage risk in investment portfolios is by holding bonds. However, we can also manage risk by tweaking a portfolio’s equity holdings to reflect current valuations and the expected investment environment going forward.
Investment theory (and over a century of data) tell us that taking diversified equity risk results in higher returns. As a result, we can confidently say that smaller companies (which are riskier than large companies) and companies experiencing financial distress (so-called “value” companies, which are riskier than rapidly-growing companies) will generate higher returns over time. However, in periods when valuations are stretched – such as we’re experiencing now – these higher-risk equities are also the most vulnerable.
In response to the changing environment, several months ago we began increasing clients’ exposure to lower-risk equities. Sometimes called “low volatility”, “defensive”, or “quality” equities, these are companies that feature low debt and high and stable profitability. These are household names that have, over many decades, developed world-class brands, logistics systems, distribution networks, supply chains, information technology, inventory management and enterprise systems. In short, and to borrow a phrase from Warren Buffet, these are the companies that have successfully built wide and deep moats around their business models.
No equities – including “quality” equities – will ever take the place of bonds as the primary method for reducing portfolio volatility. That said, in a world filled with uncertainty, we believe that tilting client portfolios toward more of these kinds of equities will enhance returns and reduce volatility during a lower expected return environment.
John Allen, CFA®
Chief Investment Officer
David Grecsek, CFA®
Director of Research
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