A Correction, We Sit on Our Hands.
The US market just dropped 10% from its peak, Wall Street calls this a correction. Historically, this happens roughly every 12 to 18 months. This latest correction is a bit more severe than usual, not because of its amplitude, but simply because it has been an unusually long time since we have seen such volatility. In the last two years the S&P hasn’t dropped by more than 5%, this long period without a discernible drop often leads to something called risk creep. In absence of a penalty, investors naturally migrate toward riskier and riskier portfolios “If I don’t feel pain, I may as well try to make more”. Bond and stock corrections tend to not happen at the same time, but all investors display that creep toward higher returns over time. Bond investors who haven’t seen a correction in a long time tend to move toward low quality corporate bonds or even junk bonds. Equity investors feeling fearless, gravitate toward high growth stocks. These high risk sectors are the ones that get hit the most in a correction. So the longer since the last drop, the more investors tend to get caught with their pants down.
“The markets are down. Marc, Alex why don’t you do something?”
Well we are passive investors, so we do not respond to market shifts, but our portfolio design process anticipates them you could say. Here are five ways in which you benefit from our approach.
- The portfolios we design that include bonds include only US government bonds. No corporate, no low quality, no currency shock, no junk, no risk creep. Note that we use only government bonds because it has been demonstrated that it is more efficient to take risk on the equity side of a portfolio, rather than take an issuer risk on the bond side.
- On the equity side we stick to passive asset classes that are tilted toward the factors of return. So here also, no risk creep. The traders inside the funds we use continuously search for small size, value, low volatility, never higher risk.
- Our optimization considers 20 years of returns. This is considerably more than say the last two years we had without correction. Our portfolios are in effect designed to perform on a period that does have corrections and even two crashes. You could say that we preemptively build all weather portfolios.
- We rebalance very systematically twice a year and are going to increase this frequency to 3 times a year. I heard at the last TD Ameritrade conference during a Blackrock presentation that because of the steady recent rise in equity the average “60% stock” portfolio actually contained 72% stock because of delayed rebalancing. This is another form of risk creep. Our rebalance discipline avoids it.
- Even though it can be tempting to try to actively predict corrections, research shows that it is inefficient to do so. Hopping out of the markets trying to avoid a correction is costly, both in taxes and in the opportunity cost of missing a market rise every time the timing turns out to be wrong. As frustrating as it is, it is more efficient to simply stay invested and take it.
“Does this mean that I should go into cash?”
No it doesn’t. Doing so would statistically be the investor’s loss. The world is at a rare moment of synchronized growth, US, Europe, Japan, China are all growing well at the same time. This is an important safety factor, it makes US growth more resilient to shocks. But please do not misunderstand me, there are issues, important ones, the sky is never all blue. The two issues I can think of that can be a source of danger for equities are trade disputes and national debt. The NAFTA negotiations and the potential Chinese trade disputes could degenerate and end up having a substantial impact on the US economy (the NAFTA dispute is more likely to degenerate than the Chinese one). As far as the national debt goes (this is also a growing issue for bonds) the budgetary discipline seems to be lost. I am not talking about the budget that the administration just released today, that is more like a cartoon, I am talking about the Congress voting a sharp (and not economically needed) tax cut and promptly allowing an increase in spending after that. Not to show much care for a balanced budget when the debt is clearly growing too fast is simply not sustainable.
Cheers.
