Six questions about the ongoing volatility
Letter from the President
Today I answer six questions you may be asking yourself about the ongoing volatility: Has the bull market ended? Could we be wrong? When might the volatility end? If we saw this coming, why are our client portfolios down? If we’re not shifting strategies, what are we doing? Is there anything clients can do?
- Has the bull market ended? We think that the ongoing volatility marks a correction, not a change in the market trend—that is, we continue to hold to our central-scenario view that the bull market we’re in the late phase of has at least 18 months to run. Our market optimism stems from our views on global growth and monetary policy. Although we observe China slowing down, Brazil in recession, and other commodity exporting economies hurting, we see no global or U.S. (or Mexican) recession on the horizon. Nor do we perceive inflationary pressures to be building. Low inflation points to loose monetary policy which together with growth should lead to renewed risk taking. If our story proves right, then, this is not a trend shift but rather a correction—the bull market will resume.
- Could we be wrong? We can always be wrong. The world and markets are unpredictable; we forecast under uncertainty. This is why, although under our central scenario assumptions we foresee a trend bull market ahead for the next 18 months, we allocate at least 20% of all client portfolios to safe assets such as long-term U.S. Treasuries that often surge when risk assets drop. It limits portfolio losses if events prove us wrong and a recession and bear market set in.
Of course, in that scenario, upon recognizing it, we would shift strategies, reducing exposure to risk assets and extending average duration in our bond portfolio.
So far, we see no reason to shift. Markets and the global economy have followed a path quite close to the one envisioned last January in our central scenario. Remember that, ever since then, we have warned that volatility was likely to break out in quarter three.
- If we saw the volatility coming, why are client portfolios down? Let me first say that we try to permanently cushion from the most severe volatility all portfolios invested over horizons shorter than two years, so I will answer in reference only to portfolios for which investment horizons exceed two years.
We have long expected volatility in quarter three but could not be sure whether it would in fact hit and, more importantly, when. Had we tried to protect clients by going to cash (for example) and then back into risk assets after we thought that a sustainable calm had descended, we could easily have mistimed our moves, subjecting portfolios not only to large transaction costs but also to potentially larger or longer losses than those they are actually incurring now by riding out or (better!) buying into the volatility.It is precisely to make sure that clients are truly able, psychologically and financially, to ride out the volatility to which our strategies expose them that we take such great care in helping them formulate their mandates.A crucial part of any investment mandate at TransEconomics is the investment horizon. When a client writes down “My investment horizon is at least two years” is saying, “First of all, I understand the risk-return tradeoff and am willing to expose my capital to episodes of potentially sharp short run portfolio losses in order to maximize returns on my portfolio over the longer run. Second, to maximize my longer-term returns, I ambothfinancially able and psychologically willing to handle potentially sharp short-term dips— as long as my portfolio is invested under such strategy that renders it highly likely to recover from any such dips in at most two years.”Right now the hardest part of what you are enduring is the psychological part—the test of your will.
- When might the volatility end? Corrections generally last three to fourteen weeks. If history repeats itself, we have one to twelve weeks to go. We expect it to be over in less than five—in other words, we see portfolios starting to recover no later than October. But of course we’re far from sure.
- If we’re not shifting strategies, what are we doing? We’re not shifting strategies because we still believe in (and in fact the ongoing volatility confirms!) our central scenario. We are, however, watching like hawks for any sign that we were wrong and should abandon that scenario and its implied strategy.By “signs”, on the macro side, I mean data suggesting that consumer demand is not responding to low energy prices, so a recession may be setting in; or a fatally erroneous decision by the Fed or some other heavyweight central bank; or signs that China’s financial distress is leading to outright financial collapse.On the market side, I mean a recession signal from bond markets such as inversion in the U.S. Treasury yield curve; or a blast-off in long-term Treasury security valuations; or bond price movements suggesting that markets now expect spiraling deflation.So far, the coast is clear. But certainly we’re in state of higher-than-usual alertness.
- Is there anything clients can do? Yes. I will list them in order of potential profitability. First highest in potential profitability, which pertains if you’re not yet saving systematically, is to start doing so now.To save systematically is to commit to depositing into your brokerage account a fixed amount of money on fixed dates at fixed intervals. You should start now.Right now, valuations are attractive, so your advisor will be able to buy high volumes of securities with your first deposit. At future dates, if prices are high, he’ll buy fewer shares with the same fixed amount; if they are low, he’ll buy more shares. Your savings regime will guarantee this, because you’ll always transfer into your brokerage account the same amount of money at invariant intervals no matter what the market is doing.Remember, no portfolio strategy has as much power to drive up your wealth as the habit of saving systematically.
Second best, if you can’t commit to a saving program but do have some excess cash, seize on today’s opportunity and transfer your excess cash to your brokerage house now. Your advisor will swoop up some bargains while they last.
Third, if you’re new to investing and have found this volatility bout to be intolerably nerve-racking, try backing off from watching your portfolio so closely. One peek four times a year at quarterly review time is sufficient. This habit will keep you focused on the long-run trend and, when markets start gyrating sharply around the trend, it will keep you serene.
Fourth and lowest in long-term potential profitably, if you can’t keep yourself from looking at your portfolio and your frequent checking is causing you severe distress, contact your advisor to report that it turns out you can tolerate less risk than you thought you could when you gave him your mandate. We will suggest a change in investment mandate and propose that it take effect after your portfolio has recovered. Under the new mandate, we’ll use a more conservative strategy. Of course, the greater stability will come at some cost: make sure that, in exchange for it, you’re willing to settle for lower long-term returns. Also, do strongly consider taking your advisor’s advice to postpone putting the new mandate into effect until after your portfolio recovers. That way you don’t lock in your losses.