To our FAI clients,
The current market volatility has some investors concerned, so we thought we would highlight a few points from our recent research that you might find constructive.
Stock Market Volatility
Since 1980, the S&P 500 has experienced an intra year decline on average of over 14%. These declines have registered a low of -3% in 1995 and as high as -49% in 2008. As can be seen on the chart below, market corrections are a much more usual event than what recent experience would offer. However, even considering the average 14% intra year decline, the S&P 500 has posted positive returns in 27 of those 34 calendar years (79% of the time!). We believe that market volatility offers FAI clients increased return opportunities. We plan on taking advantage of market declines produced by investor panic.
Red Dots – Intra year decline
Grey Bars – S&P 500 Return For the Year
Source: Business Insider, Standard & Poors, Factset and JP Morgan
Bear Market Potential
Most bear markets are driven by one or more of the following five factors: Black Swan Event, Valuation Bubbles, Weak Business Fundamentals, Recession, and Illiquidity/Financial Leverage).
Here is our current thinking on each of these bear market drivers:
Black Swan – A black swan event by definition is impossible to predict and can happen at any time.
Valuation Bubbles – We have been saying for some time that we believe the stock market is overvalued, but we don’t believe it is anywhere near a “bubble”. See chart below:
Weak Business Fundamentals – Although reported numbers for the S&P 500 have fallen in 2015, much of the decline can be explained by the strong dollar. (See chart below). This causes companies to restate foreign income earned in other currencies in to U.S. dollars which appear weaker because of the accounting translation. This is an accounting feature and does not reflect real economics for the company as they earn foreign currency and pay their bills in foreign currency. Analysts estimate that foreign currency has cost the S&P 500 about 6-8% of earnings growth. So, ex currency, earnings for the S&P 500 would have increased mid-single digits for 2015.
Source: JP Morgan
Recession – Although we have seen some weakening in the main economic indicators, they are not suggesting a recession at this time.
Illiquidity/Financial Leverage – Markets are awash with significant liquidity from Central Bank intervention over the last few years. This along with much better corporate and consumer balance sheets leads us to believe that this factor is not an issue at this time.
Source: Business Insider
FAI understands all of the above issues and manages its portfolios in a diversified manner to protect against any one occurrence or market decline. This investment style has served our clients well over the years as it reduces portfolio volatility and increases full market cycle returns by preserving capital in severe market declines. Here are a few areas within the portfolio that should help protect clients during severe market downturns:
Equity Asset Allocation - We increase our stock ownership when value opportunities present themselves and decrease our allocation when valuations are high. Heading in to the summer of last year, we were underweight equities. After the 10% sell off in August, we added to our equity positions. Because of the subsequent market recovery and deteriorating economic conditions, we reduced our exposure again at the beginning of this year. This provides us with “dry power” should a more severe market decline materialize.
Treasury Bonds – Treasury bonds have been beneficiaries of the “flight to quality” that occurs during times of market distress. For that reason, we see them as an integral part of our investment portfolios. During the last three market downturns, Treasuries held up very well.
2001 2002 2008
10 Yr Treasury +5.6% +15.1% +20.1%
S&P 500 -11.9% -22.0% -36.6%
Gold – Gold has also proven to be a beneficiary of the “flight to quality” and should provide the portfolio with volatility reducing qualities, especially during black swan events. It also should provide some protection against inflation which erodes client purchasing power.
Lower beta /higher quality stocks – Our style leads us to own lower beta/ higher quality stocks in the portfolios. These companies generally have higher growth rates, better profitability, higher returns and better balance sheets than the market as a whole. Although they at times will lag in a bull market, they should provide some protection during bear market declines.
Tactical Mutual Funds - These funds have the ability to own both long and short positions. The short positions allow these funds to potentially generate positive returns, even in large market declines.
So, in summary, although we don’t have a crystal ball and can’t predict the future, we currently don’t foresee a true bear market. However, we do foresee a significant increase in stock market volatility over the next few years. We believe that this volatility represents more of a normal market environment after much governmental intervention. We do not fear the increased volatility. On the contrary, we view the increased volatility as an avenue for FAI to take advantage of market fears and add value for our clients.
Curtis Gross, CFA
Chief Investment Officer, FAI
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by FAI Wealth Management), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from FAI Wealth Management. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. FAI Wealth Management is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of FAI Wealth Management's current written disclosure statement discussing our advisory services and fees is available for review upon request.