End of an Era
October 13, 2014
“An era is ending: for over half a decade, nearly worldwide, zero interest rates suppressed volatilities. That is over. More and exciting volatilities lie ahead.” – David Kotok, October 5, 2014
The third quarter ended eventfully with a resurgence in world-wide volatility in stock prices, interest rates, currencies and commodities. This volatility carried over into October as most days so far the Dow has experienced 100 to 200 point swings rather routinely. A lack of global liquidity has also created a resurgence of volatility as the Federal Reserve wraps up its quantitative easing (QE) program. It’s no secret that QE aids global liquidity and risk assets such as stocks. Cross-currents in Central Bank policies also add to volatility. The US and the UK are now looking over the horizon and deciding when to start raising interest rates from zero bound. Meanwhile, Europe and Japan remain at zero and are looking for more ways to add to their own quantitative easing programs.
The end of the quarter also saw the hasty exit of Bill Gross from PIMCO, which no doubt added to volatility as PIMCO manages more than $2 trillion in global assets. In his first letter to clients at his new firm Janus, Gross echoed his views while at PIMCO saying current financial markets are “artificially priced.” It’s hard to argue as he notes there is nothing normal about a 2-year German government bond yielding “minus” .10%. That’s right, investors are paying the German government to hold their money!
Volatility is nothing new in financial markets. One only needs to look at the S&P 500 since 1997 (see figure 1 below). The market has seen its share of volatility in the recent past. What’s been interesting during the past few weeks has been the reaction to all the added volatility. Pullbacks anywhere from 5 to 10% in stocks is a very normal phenomenon. US stocks are only 5-7% off their 52-week highs and international markets have come further off their highs, around 12%. The global stock market is up 10% annually over the past 5 years and returned a healthy 23% during 2014. It’s not unusual for markets to take a “collective breath” after such a strong year in 2013. What’s also possible is many investors continue to suffer from “recency bias” as the fear of the 2008/2009 recession remains in the forefront of their minds.
Figure 1: S&P 500 Index at Inflection Points
Source: JP Morgan
So how do you combat volatility in a portfolio and still maintain a long-term view? A manager that I have used for many years, Jeffrey Gundlach, has said
“The trick is to take risks and be paid for taking those risks, but to take a diversified basket of risks in a portfolio.”
What Gundlach is communicating is not to blindly invest in risky assets just to seek higher returns, but to be selective in how and where you take your risks. In every market environment there are opportunities. Markets are not perfectly efficient, but rather I believe, somewhat efficient. To me that means using a mix of both active and passive strategies in a portfolio.
Seek out active managers that can provide downside protection in stocks and other risk assets. In the bond market, especially in today’s market, look for low cost active managers that have the ability to “take risks and be paid for taking those risks.” Holding cash is also not a bad thing in many market environments. Cash can provide a “dry power” asset if and when markets enter a larger correction. One way to hold cash is through active managers. This takes away the need to force a decision from the asset allocation level to hold cash. Steve Romick at FPA Crescent for example, holds 45% of his portfolio in cash as of the end of the third quarter. Let the active managers make the cash decisions for you.
The end of an era of zero-bound interest rates and quantitative easing may be beginning. If so, get used to added volatility in financial markets. Now more than ever is a time to be vigilant about the risks one takes, but still maintain a long-term perspective.
Markets By The Numbers
Global stocks ended the quarter down 2.3%. The weakest area of the market was developed international stocks as investors fretted over geopolitical risks, slowing growth and a risk of deflation in the Euro-zone. US stocks were once again the best performers with the S&P 500 rising 1.1% during the quarter. For the year, most markets are showing positive returns with small cap stocks bringing up the rear. Despite a volatile quarter, all markets have been in bull market mode for the past 5 ½ years and also higher than normal 10-year annualized returns. Keeping a long-term perspective is important.
Most U.S. bond markets were modestly higher during the quarter, while international bonds declined. Surprising most investors, the bond market has been very strong during 2014 with the Barclays Aggregate bond returning 4.1% year to date. As interest rates have consistently dropped over the past 10 years, bond prices have risen. With global interest rates near zero, the future looks less bright for the bond market. However, bonds deserve a place in any diversified portfolio.
The third quarter was a tale of two markets for commodities and the US dollar. Perhaps the most volatile of the markets, commodities suffered a 12% drop during the quarter. Commodities were hurt by a stronger dollar which rose 7.6% during the quarter, slowing global growth rates, and inflation near non-existent across the globe.
A balanced portfolio of 60% world stocks and 40% bonds declined 1.3% during the quarter and is higher by 3.9% so far this year. Despite the 2008/2009 global recession, a balanced portfolio has returned 6.2% annually since October of 2004.
Cumberland Advisors Commentary – Volatility. Available online http://cumber.com
JP Morgan Guide to the Markets – 4Q 2014. Available online http://jpmorganfunds.com
Investment Outlook – Bill Gross, October, 2014. Available online http://janus.com