September 2011 |
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Extreme volatility has been the norm over the past two months. During this time, the market has experienced nearly triple the average daily volatility typically seen. The stock market nearly hit its 2011 high in early July and within only a month it had fallen dramatically by as much as 17%. It has certainly been a rugged path for many investors. We have always believed the smoothness of the path matters and thankfully we continue to use shock absorbers to help manage our clients’ money, especially in this kind of market environment.
Our focus today is to prepare for a recession and develop a strategy for the eventual recovery. Many of the economic indicators we follow point to a continued economic slowdown in the months ahead. Unfortunately, if that occurs, our economy simply hasn't been growing fast enough lately to avoid a recession. We feel that any rally of significance is to be used as an opportunity to better protect portfolios.
After a partial recovery from its early August low, the stock market at the time of this writing is down only 5-10% from its recent high. The average recession produces losses of around 25%-35%. So, the onset of a recession points to much more pain ahead for investors. Our objective - as always - is to prepare for this not only by protecting portfolios but also positioning them for what comes after. It should be obvious by now that we’re not passive types.
At the start of each client relationship, we are given a predefined “risk allowance” that we use in our active management process. Within this risk allowance, it is clear that some volatility is acceptable to our clients in our search for reasonable longer-term returns. We are fortunate that we’ve been given a large amount of flexibility that matches the size of our management responsibility. Given the recent extreme volatility as well as the economic uncertainties over the past few years, possessing and using this flexibility has been especially important.
Our simple goal is to produce better - that is, smoother and larger - returns than we’d otherwise produce if we simply chose to passively invest our clients’ money regardless of the environment. No investor has a magic formula to pick market tops and bottoms perfectly. That’s why we stress the words smoother and larger above!
It is very difficult to pick the absolute bottom - clearly - and we cannot consistently do it. When it happens, we’ll be sure to chalk it up to a good amount of luck. This means we must be willing to accept some level of decline during a downturn in order to be positioned for much better gains upon the inevitable recovery. In other words, we always view things over their full cycle and we are inherently optimistic investors despite our tone over these past five years!
For now, we are assuming that a recessionary bottom this time around could be in the range of 900-1000 for the S&P 500 Index. This would basically set the stock market back to levels seen in late 2008. A decline of this magnitude would erase about half of the last recovery's gain. While it sounds ugly, a 25%-35% decline is historically consistent with normal recessionary downdrafts in stocks.
It is important to note that we are not making concrete and final predictions here. No investment manager should ever value so highly others' perception of their credibility that it comes at the expense of their flexibility. In times of economic uncertainty, like today, conditions do change. You should expect us to swallow our professional pride and change our strategy if we believe it is required.
However, if a recession does arrive and the stock market weakens as we expect, we plan to independently and simultaneously “turn the dials” we have to manage risks for our clients.
First, as markets fall, we plan to scale into attractively priced stocks – bit by bit – with a greater focus on adding more economically-sensitive stocks to our portfolios. During the heart of the July/August swoon, we did just this.
Second, as the stock market hits certain levels, we also plan to methodically trim-back and ultimately eliminate our shock-absorbing stock market hedges. We’ve been much more active with this particular dial lately as well.
Given our concerned view of the market’s direction, it is very fair to ask why we would not just choose to hide out in cash in the meantime. There are a couple of reasons we like our approach.
One, we know there is no fail-safe way to consistently time a market bottom. We've seen markets turn on a dime in the past with only a small shift in investor sentiment. This shift happens far before the widely watched economic indicators turn positive. We experienced this in the spring of 2009 during the "green shoots" debate. We’re humble enough to realize that it could happen again at any time during this economic cycle. While we see warning signs all around, a recession is never a certainty. This is especially true with very active government policymakers in the mix.
Given the possibility of a turn in sentiment, our “turn the dials” strategy recognizes the importance of always being in the process of building a portfolio of attractively priced stocks during the entire down cycle. If we decide a truly sustainable recovery is afoot far sooner than we anticipate, we'll simply unwind our protective hedges and let our only partially-built portfolio do its job.
Two, by attempting to time things perfectly it naturally keeps a money manager “out of the market” at a time when individual stocks get very cheap all over the place. When this happens, keeping protective stock market hedges in place effectively "blinds" a manager from seeing the bargains. To play both sides of the coin - that is, buying attractive stocks yet still remaining largely hedged - almost requires you to act as if you have a split personality. That affliction is not all that common among rational investors, a group in which we'd include ourselves.
Turning the dials to actively adjust the risks we take for our clients is admittedly a challenging part of our job. However, it is an essential part of what we do and who we are. While uncertainty is not new, we are currently living in a time where the speed of change is accelerating. It is a time where headlines and rumors from across the globe significantly affect sentiment and the markets on a whole new scale.
Fortunately, we’ve been given enough tools and we have enough professional independence to do our work without the usual excuses. We understand the stakes.
