Living Near the Fault Line

By Steven Smith | Investment Management

Aug 26

Unless you haven’t been paying attention (and kudos if you haven’t) you know that the last week or so has seen a significant sell off in the world stock markets.

Ordinarily, I’m loath to fall into the financial media’s trap and ascribe market moves to any particular cause(s). But a few things have been happening at once: 1) China’s economy is slowing. But due to the Chinese government’s tendency toward secrecy, it’s impossible to know by how much. (The Chinese stock market has been in virtual free fall. But that appears to be a symptom of the Chinese economy and not really a direct catalyst to action in the US market.) China has become such a significant player in the world economy that there is legitimate fear of contagion in the rest of the world. 2) The price of oil dropped below $40 per barrel, down more than 50% from a year ago. Continuing US and Saudi production as well as the possible impending nuclear agreement with Iran are affecting the supply side. Low prices will certainly affect the fortunes of the factors of production in the oil patch. But traders are more worried about the extent to which price declines may be attributable to falling demand amidst a slowing global economy. 3) The long but tepid economic recovery combined with a six year sustained bull market.  4) The Fed had been (is it still?) inching ever so closer to raising interest rates for the first time in eight years.

California Dreaming

Investing is a lot like living near a fault line in a beautiful place like California or the State of Washington. (Here in Colorado, our fault lines are not for earthquakes; but rather blizzards, floods and forest fires.) In the geology that creates the magnificent coast and inland forests that attracts us to live in these beautiful places lies a danger that could disrupt our lives. Similarly, we invest in the capital markets seeking the rewards they offer to enhance our financial futures and those of our families and charitable beneficiaries. Accompanied by the risk.

We experience the occasional temblors. They unnerve us. But it is impossible to know whether it is “the big one.” When we choose to live in these beautiful places, we know and understand this but accept the trade-off. Likewise, with the markets, if we are approaching them rationally. Nobody knows if we are headed for another move down, whether the market will be flat for a period or resume its upward course.

This (Probably) Ain’t 2008

Having lived through and survived the Great Recession and stock market crash of 2008 – 2009, it could be easy to project that kind of result on to this – or any other – correction. The top to bottom decline in the S & P 500 Index between October 2007 and March 2009 was 56.6% — the worst decline other than the crash of 1929 and the ensuing Great Depression. But 2008 was the result of enormous, largely hidden, systemic risk in the global financial system involving banks insuring each other for losses in the highly leveraged real estate mortgage markets. It was a lot like a house full of termites not discovered until it was too late. That catastrophe was one of Donald Rumsfeld’s famous “unknown unknowns.” This seems to be more a case of ordinary “known unknowns.”

Corrections are Healthy

Declines of 10% or more occur regularly – on average once every 18 months. We haven’t had one for an unusually long 4 years. Historically it has taken on average 10 months to recover from a typical correction. Corrections tend to shake short term traders out of the market and create opportunities for long term investors to harvest losses for tax purpose, rebalance and put new money to work.

Having a Plan

The lynchpin to managing during turbulent times is having a well-conceived and carefully implemented plan. Make sure you have enough in cash and short term bonds to cover short term needs and also to endure a bear market should one emerge. As part of your planning it pays to perform a number of stress tests demonstrating that this kind of short term decline isn’t nearly enough to unravel your plan. My hero, John Bogle, founder of Vanguard, always counsels during times like these: “Don’t do something, just stand there.” But you can only take such advice if you have a well thought out plan and a diversified asset allocation you can live with.

They Don’t Call it a Risk Premium for Nothing

When establishing your investment plan one of the most important aspects is determining your willingness, ability and need to tolerate stock market risk in pursuit of the long term expected rewards. Understanding your risk tolerance is not an abstraction; especially during moment like these. If the risk never showed up the premium for bearing that risk wouldn’t exist.

See the Forest for the Trees

It is imperative not to be viewing the component parts of your portfolio in isolation from one another. Focusing on the parts instead of the whole can cause you to make emotional decisions. Like modern construction in the Bay Area, portfolios should be constructed (by combining risky – return seeking asset classes – with less risky – ballast providing ones) to withstand even some of the most damaging shocks. High quality bonds have done their part this week and increased in value during the “flight to quality.”

Computerized Trading

One of the interesting aspects of this week’s activity has been the role of computerized trading and the peril it poses for anyone other than long term investors.

In the age of computerized, algorithmic trading — adjustments which may have taken weeks or months in the past can now occur in just a matter of days – or even hours. At the open on Monday, the Dow Jones Industrial Average appeared to have gapped down 1,000 points even before a number of the components had opened for trading. The use of Exchange Traded Funds (ETF’s) as a vehicle for large bet, rapid fire, short term trading caused significant disparities between the prices of the funds and the values of their underlying baskets of stocks in certain of these securities. (That doesn’t occur with regular open end mutual funds which can only be traded at net asset value after the market closes.)

Virtu Financial, one of the principal players in the High Frequency Trading (HFT) arena reported one of its busiest and most profitable days ever. God bless them. But for regular investors these are very difficult days to be trading. One of the best things about having a time horizon measured in decades is you don’t have to worry too much about the dangers of this frenetic activity.

 

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