Market Update (2/5/2018)

I had hesitated to send one of these out after the two-day pullback in the market because while it looks bad on a point basis (Dow, S&P, etc.), it’s far from exceptional on a % basis, which is what counts. After today’s fall, the S&P is down a little over 1% for the year. Some other assets classes are down a bit more, others are still up on the year. This is far from “Markets in Turmoil”, but that business news headline attracts attention, raises fears, and up go ratings. Because of that, I thought a quick note was warranted to both show there is not turmoil at this point and to give you my perspective on what’s going on. Here’s a quick look at year-to-date performance (including any dividends paid) by asset class (representative ETF) AFTER today’s “plunge”:

US Large Cap (SPY): -1.1%

US Small Cap (VB): -2.7%

Foreign Developed (VEA): -1.5%

Foreign Emerging (VWO): +1.7%

Real Estate Investment Trusts (VNQ): -9.9%

High-Yield Bonds (HYG): -1.3%

Aggregate Bonds (BND): -1.4%

Short-Term Investment Grade Credit Bonds: CSJ: -0.1%

Local Currency Emerging Market Bonds: +2.5%

Aggregate Commodities: +0.5%.

As you can see, with the exception of REITs, which are getting beaten up as interest rates rise, this is far from turmoil.

What happened today is concerning though. Stock markets behaved erratically. Futures liquidity dried up as this started to happen and liquidity in the S&P 500 futures contracts after-hours tonight are as low as they have been in a long time. That means it’s fairly easy to push the market around with relatively small orders, causing big moves in either direction. As a result, S&P futures have been moving 10+ points repeatedly over only a few minutes throughout the evening (this is the equivalent of the Dow moving in about 100 points per few minutes). The markets are down sharply overnight, with recent lows having Dow futures down another 1100 points from today’s close and S&P futures down a little over 100 points. This isn’t being caused by economic issues, bank liquidity issues, terrorism, recession, or anything that caused the last two major (-50%+) market falls. In my opinion, it’s being caused by large, leveraged bets on continuing low volatility which are unraveling in what should have been some mild profit-taking and re-pricing as interest rates moved a bit higher in January. Volatility has been running well below normal as I’ve pointed out in recent quarterly updates. Futures markets generally price in a return to normal volatility over time. Therefore, if one shorts future volatility in futures markets (or via multiple exotic ETFs and other financial products) and volatility remains low, money can be made over and over again very quickly. Hedge funds have been started that engage in this tactic and it has paid off massively over the past year as there has been virtually no volatility in the stock market. The longer the strategy pays off, the more money moves into it, chasing its success. People / funds begin to borrow money to invest in the strategy (leverage) because they can pay a few % of interest per year for their borrowing costs and make 10%+ per month if the strategy continues to do well. For all of history this has been a recipe for disaster and sure enough, it is beginning to unravel. An otherwise ordinary increase in volatility surrounding a few days of rising interest rates / declining stocks causes these bets on low future volatility to lose massive amounts of money very quickly. Fear that they won’t be able to pay back their loans causes margin calls which forces more selling of this strategy. Selling of short volatility funds is essentially buying volatility into a spike in volatility, which causes (of course) more volatility. Other hedge funds know this is happening and try to take advantage of the forced volatility buying (stock selling) causing even more. From there, it’s the same old vicious cycle that has fueled market drops like this in the past. Want proof that this is what’s going on? Today was the single biggest % increase in the VIX (the volatility index) in the history of the market on what wasn’t even in the top 100 down days on a % basis in the history of stocks. Want more proof? Here’s the after-hours chart of an exchanged traded note that tracks the inverse of the volatility index (I know that’s a mouth-full… it’s basically one of these short-future-volatility funds that is blowing up):

You’re reading that right… -86.04%, just since 4pm today! This is going to cause some hedge fund meltdowns. It’s going to cause some margin calls. It’s going to strain markets for a while. But I find it hard to believe an obscure greed-based strategy is going to bring down earnings growth, which is really starting to pick up around the world. That’s not to say there aren’t other factors playing a role here, but I think this short-volatility blow up is a big part of it. Another cue that this is probably a shorter-term event is that it’s not flowing through to currency markets at all (at least not yet). Despite futures being down 4% overnight, the dollar index, a normal flight to quality when there is a lot of fear in the market, is up only 0.1%.

Anything is possible, and as I’ve said many times, I’m certain that the stock market will eventually fall more than 50% again. We probably won’t see it coming in advance of that happening. But, if someone forced me to place a bet, I would bet that this will be a fairly short-term event that will allow the market to build again from whatever bottom that forms. To be clear, I’m not advising anyone to invest money they wouldn’t otherwise invest as a result of this. I’m not advising anyone to be more aggressive or conservative in their portfolio or to reposition assets in any way (other than usual rebalancing) as a result of this. Financial plans are designed to weather market moves, not predict them, and not time them. I know seeing your portfolio value fall hurts. For some of you, it makes you want to sell stocks. For others, it makes you want to aggressively buy stocks. But it is going to happen over and over again and is the price you pay for the kind of growth you’ve experienced over the past several years. Markets can’t only go up, despite what they’ve done in the past year. We’ll be rebalancing client portfolios on the way down (sell bonds, buy stocks), just as we rebalanced in the other direction (sell stocks, buy bonds) on the way up. And, it never hurts to have your planned contributions and 401k deposits go in at a lower level than they otherwise would have.

In short, expect that wild swings in either direction are possible over the next several days. I hope that with the explanation above, you’ll find what happens more interesting than traumatic. As always, if you’re reading this as a PWA client, feel free to contact me with any questions.

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Brexit

As I type this message, the votes are being counted in the UK referendum on whether to remain in the Euro zone or exit (British Exit, “Brexit”). With approximately 2/3rds of the voting areas reporting, the result looks like a narrow victory for the exit camp. This comes as a total shock to the financial markets, which had been pricing in a win for the Remain side, based on recent poll data, and similar votes in other countries in recent years. Virtually all economists are in agreement that this will have a detrimental impact on UK GDP, at least in the short-term, and maybe in the long-term. It also signals a possible unraveling to the Euro zone if other countries reach similar decisions. The future impact is all based on speculation at this point. Is it better for the UK to extract itself from a potentially failed experiment in trying to combine countries in Europe that are too culturally different to be combined, even if there is some short-term economic pain? Might it even be better for the world if the countries of the Euro zone all return to their previous status as completely separate entities that are not as dependent on each other? Or does the obliteration of trade agreements, a common currency, and a determination to become more unified wind up hurting global growth irreparably? No one knows these answers.

What we do know is that when financial markets are shocked by an unexpected event that MAY have major economic implications for the future (MAY emphasized, because whether it does have those implications or not is irrelevant), volatility ensues. In this case, it is led by the currency markets as the value of a British Pound can change dramatically if the market in aggregate believes now that investments in the British economy will offer poorer returns in the coming years than they did yesterday. Major swings in one currency often trigger major swings in other currencies in a rush to safety (US Dollar) and away from riskier and higher yielding currencies. Currency swings impact the economies of the countries that use those currencies. Currencies that depreciate in value gain an export advantage over other countries, but the cost of imported goods can rise sharply and hurt more than the exports can stimulate growth. Stock market fluctuations follow from the economic impacts and volatility there can be self-fulfilling as leveraged losing bets cause additional forced selling via margin calls and fund liquidations. In financial markets, fear begets fear. As you might expect, the British pound is incurring substantial declines in overnight markets… currently down almost 10% vs the US dollar, back to levels not seen since 1985. World equity markets are also suffering, with US markets down 3-4%, the UK down 7.5%, and Asian markets down as well. US bonds are a bright spot, as is almost always the case in situations like this, which is the reason we include bonds in your portfolios even when interest rates are low. They are a source of stability and are negatively correlated with other assets.

While it’s always possible that there will be a quick snap back rally, events such as this tend to take a while to play out in the markets as bottom-pickers try to time their bets (exerting buying pressure and causing a rebound in prices), while funds with liquidation requests and leveraged bets that led to margin calls force additional selling (downward pressure) on the markets. As is usually the case, the market knows best what a fair price is given the current situation, so we don’t see this as a reason to panic and sell, or a particular “buying opportunity” beyond the investing of spare cash that you should always be doing and that’s part of your financial plan. It’s merely something that has now happened and is priced into the markets. Over the long-term, the economic impacts will play out, and prices will continue to adjust as those impacts are better understood.

The long and short of Brexit is this: tomorrow is likely to be a very ugly day in most financial markets. The gains of the last few months are likely to be wiped out (and then some). Will that change the fact that over the long-term, populations will continue to grow, people will continue to work, and productivity will continue to increase through process and technological advances? Call me skeptical, but I doubt it. The world’s economic output, in all likelihood, will continue to grow over time and we’ll look back on this as yet another event in the history of financial markets that caused a lot of headlines to be written and a lot of fear to swell over a temporary blip in overall growth. We have no idea whether the UK will benefit or be hurt by their democratic decision (if they even go through it). But the world as a whole will be just fine after some time to adjust to the new landscape. In other words, I sincerely doubt any of you will be telling your grandchildren that their lives would be so much different if only 2% more of the UK voted to stay in the EU on 6/23/16.

The Value Of Volatility

When the market falls, especially after a strong upward run (4+ years in this case), I think it’s worthwhile to remind everyone about the value of volatility. To keep it simple, let’s just think about a simple portfolio containing all US stocks and no bonds. This is what I would consider to be an extremely aggressive portfolio, one that would be hit very hard by a bear market like we had from late 2007 to 2009. Let’s look at 2 cases, with the stock index in both cases shown in the graph below:

Case 1: Reality (Volatile Market) – Using the actual performance of US Stocks from late 2007 to the end of 2012, suppose you had a $100k portfolio in September of 2007, just before stocks peaked and started heading lower. Your financial plan for retirement called for $1k per month contributions consistently (think of this as your 401k for example). The market tanks, losing almost 50 of its value by March 2009, and then slowly comes back to surpass where it started. By the end of 2012, you would have amassed a sum of $196,024.60. That’s your original $100k + $63k in contributions + over $33k in gains.

Case 2: “Ideal” (Market Never Falls) – In this case, we’ll pretend that the stock market moved in a slow straight line starting at the same value as in Case 1 and ending at the same value as in Case 1, but with no volatility. It never had a losing month and just kept slowly increasing. Let’s start with the same $100k and add the same $1k per month. This would feel much more comfortable. You could look at your statement and see constant progress… slow and steady. No sweating, no heartburn, no temptation to sell or alter your contributions. I call this the “ideal” case in quotes, but it’s actually far from ideal. In this scenario, you would have ended 2012 with $180,931.30. Again, your original $100k + $63k in contributions + ~$21k in gains. That’s only 2/3rds of the gain with the volatile portfolio, simply because you never get to add your $1k per month at lower prices.

The moral of the story here is that if you’re adding to your portfolio regularly, you really should be hoping for the market to fall from time to time, not rise, so that you can buy at lower prices. Sure, you want the market to rise right before you need to withdraw money, but until then, the lower it goes (a la March 2009), the worse it will feel, but the better it will be long-term. Volatility is the real “ideal” for the long-term investor.

Volatile Markets & Active Trading

***This post was originally published in PWA’s Newsletter: The Pretirement Press in Q1 2008 and it’s publish date has been edited here to reflect the approximate initial publish date***

The sharp up-and-down in the markets tends to draw more market-timing traders in. These speculators attempt to profit from momentum by buying when the market is going up and selling when it’s going down, creating even more of a whipsaw effect. For the inexperienced investor, it can be tempting to try to pick a top or a bottom in the market and profit from these wide swings. There are four issues with doing this.

1) You need to pick the right top to sell your investments and if you’re wrong you risk missing the upside.

2) You need to pick the right bottom to buy back into your investments.

3) You need to pay taxes when you sell (assuming you have gains), which means you’ll be unable to buy the same amount back later.

4) You pay commissions to your broker each time you make a trade.

Brokers will win with this strategy since they collect trading fees. Uncle Sam will win with this strategy since he collects taxes. A few individuals will win with this strategy if they pick the exit and entry points correctly. Everyone else will lose, and will experience much more long-term volatility than necessary. A much more successful strategy is to work with your advisor to outline your goals, the returns you need to achieve those goals, and implement an asset allocation that is designed to target that return over the timespan you need. You can’t measure it over months, you won’t get the exhilaration of a “winning trade”, and it won’t be as much fun to try. What you will get is enough money to fund your lifelong aspirations and that should be much more meaningful than occasional short-term wins.