The Curious Case of Calm
Updated: Sep 6, 2018
"Be fearful when others are greedy, be greedy when others are fearful." -Warren Buffet
As I pen the inaugural Arrowroot Family Office newsletter, I notice something a little unsettling in the markets. It’s calm, everywhere. Where did all the fear go? It seems like it was just yesterday that the talking heads on television were contemplating the end of the market as we know it. With the US equity markets continually rising, tech giants conquering more and more market share from every industry, and historically low interest rates, investors appear to be as comfortable as ever taking risk. In this newsletter, I’ll cover some reasoning behind this risk-taking and a few ways we manage our clients’ portfolios to maximize returns from this exuberance while protecting the downside related to cyclical and systemic disruptions.
In August, the Dow Jones Industrial Average (“the Dow”) passed 22,000. It marked the 32nd record high of the year for the Dow, and a far cry from the Great Recession bottom of approximately 7,000 in 2009. A new summit was not reserved exclusively for the Dow, as the NASDAQ and S&P 500, representing technology and the broad U.S. market respectively, reached new highs this year as well.
To be fair, there are many reasons for the markets to rally:
For companies, the low interest rate environment has made it cheaper to access cash, which may result in increased investment in their businesses.
For fixed income investors (retirees, pensions, foundations), low interest rates force these investors to search for returns beyond traditional sources of conservative investments (municipal bonds, treasury bills, CDs) as they yield little to nothing. This may result in increased market participation, expanding P/E ratios, and ultimately higher stock prices.
Anticipated deregulation and tax reform may result in healthier bank accounts for corporations and investors alike, fueling further investment.
Recent strong corporate earnings may continue in the near- and mid-term.
Going through the “Great Recession” made many companies cut expenses and re-emerge leaner and meaner, which may increase profitability moving forward.
An increase in technological advancement may result in anticipated higher future growth rates as inefficient, antiquated methods are replaced with their superior tech counterparts.
If only one or two of the above market drivers are fully realized, it’s entirely possible that the dance will continue. However, what I find troubling in this investment hubris is the lack of calculated risk-taking. The disregard for risk is also evident in the high yield fixed income market. With interest rates at historic lows, income-seeking investors have been willing to take outsized risk to receive even a modest return. For example, looking at the US High Yield Option-Adjusted Spread Index, we see that high yield bond (junk bond) spreads have contracted back to 2007 levels. Investors are taking on extra risk in order to receive small returns over what they would receive investing in traditionally safer bonds (treasuries). In fact, the spread has not been this tight since right before the “Great Recession.”
If you consider the points above too opaque to draw a conclusion, consider the VIX. The VIX is the Chicago Board Options Exchange (COBE) Volatility Index, affectionally known as the Fear Index or Fear Gauge. When the VIX is high, the volatility represents a perception of fear and uncertainty. Whereas when the VIX is low, the perception is that there is a high degree of market safety and low volatility observed in the market. This past May the VIX had its lowest monthly close, ever. In July, it hit a 24-year record low when it dropped to 8.84 before closing at 9.6. While in recent weeks we have had modest spikes, the VIX has still primarily stayed in the low to mid teen range. To put those numbers in perspective, the VIX closed at 80.86 at the peak of the market volatility and meltdown in November 2008. Investors no longer have a healthy fear of the equity markets.
Typically, when people present the above facts, it’s from a contrarian perspective, not unlike the sage wisdom from Mr. Buffet that I included below the title of this newsletter. But like all good advice, it should be taken with a grain of salt. The alarming lack of fear in the market is a subject that many bear investors (those that believe the market is poised to go down) have echoed since before the presidential election. Regardless of partisan viewpoints, there has clearly been more global uncertainty since then related to: trade relations, fiscal policy, health care, terrorism, and geopolitical instability. Yet the markets continue to rally. During the last rolling 12-months since the beginning of August the S&P 500 is up almost 13.5%.
So where does this leave us and how should we proceed? We invest for the long term for our clients. In doing so, we use strategic allocation for their portfolios while maintaining the flexibility to make high conviction tactical changes as warranted by market conditions. Given current conditions, we do not believe it is necessarily a time for fear, but rather, it is a time for investing mindfully.
Based on our current monetary policy expectations, we’ve reduced our exposure to longer-dated bonds, which would be the most drastically and detrimentally affected if/when interest rates rise. In general, interest rates and bonds have an inverse relationship - when interest rates rise the value of bonds go down. In addition, the higher the duration, the more the bond will go down in value if/when there is an interest rate increase. We don’t know when the next rate hike will occur, but we feel confident that we will have one or several over the next three years, assuming there are no major economic concerns in the interim.
Given current stock market valuations and where we believe we are in the current economic cycle, we do not think it’s prudent to simply rely on the broader market to provide returns for your portfolio. In our opinion, performance will require greater scrutiny, monitoring, and decisiveness.
When appropriate, both stocks and bonds will remain core components for clients’ portfolios. However, we believe it is imperative to stay nimble and long-term focused. In equities, we see opportunities internationally for higher economic growth and attractive valuations. Meanwhile, we see fixed income as a valuable tool for diversification purposes and to reduce economic and market risk exposure. We maintain the view that with yields sub 1%, cash is best used as a safety fund and to manage cash flows, but not as an investment. Given our market expectations, we believe an increased allocation toward alternative investments may be warranted for certain portfolios.
People typically define “Alternative investments” in broad terms, representing any investment outside of stocks, bonds, and cash. They show the greatest disparity of returns from top to bottom quarterly investments, meaning there is a wide range of potential investment outcomes unlike other asset classes that tend to trend closer together. For our clients, alternative investments are typically deployed through: private equity, private notes, hedge funds, and direct equity and real estate investments. We find alternatives as a suitable investment not only because of our traditional market expectations, but also for their ability to achieve strong risk-adjusted performance and alpha generation potential.
As we look towards the future of investing it is important to realize that we cannot depend on perpetual bull markets to generate double digit returns, and risk will exist whether we choose to acknowledge it or not. It will be thoughtful portfolio construction, discerning investment selection, and investment mindfulness that will allow us to prevail.
On a personal note: as I evaluate current economic and market conditions, I am excited to be part of a firm that is committed to innovation, doing what’s right for their clients, and not stuck in the status quo. I hope you find this newsletter helpful and look forward to meeting you as we work together.
Ryan De Silva, CFA, CFP®
Arrowroot Family Office