What We’re Thinking

With a volatile third quarter now ended, it may be helpful to offer some historical context for the recent market declines. Since the financial crisis in 2008, stock prices have had only one substantial period of decline (approximately 20%), in 2011. Since this has been a long period of generally steady stock price increases, it is perhaps reasonable to point out that stock prices are “due” for some declines. Interesting historical statistics were presented in a recent article in Investment News magazine (9/14/15, page 3), which advocated a buy and hold approach to price drops, rather than trying to time the markets in an attempt to be out while prices are falling and in when they are rising.  The article notes that since 1945 there have been: (a) 59 periods of declines between 5% and 10%; (b) 20 periods of declines between 10% and 20%; and (c) 12 periods of declines of more than 20%. In all of these periods, there have been recoveries from the declines, in varying time frames dependent on the severity of the decline. The article observes that “the majority of market returns occur in a small minority of days and that the big return days tend to be unpredictable and hot on the heels of awful news. ” It also states that “buy and hold is a relative concept that needs a certain amount of flexibility to allow for liquidity, rebalancing and various life events such as retirement.”

At Park Piedmont Advisors, these are core components of our investing philosophy. And this is why we focus so much on appropriate asset allocations specific to each clients’ circumstances, which we then expect our clients to be able to maintain during periods of declining stock prices.

The much awaited decision by the U.S. Federal Reserve as to whether to start raising interest rates was answered in the negative yesterday, while still leaving open the possibility of an increase before year end. “Heightened uncertainty abroad” and “prospects of low inflation,” both of which are reasons not to raise rates, were deemed more important at this time than “improving labor markets” and “reducing slack in the economy,” which would have been reasons to start raising rates

Financial markets had little reaction. Stock prices rose initially but ended the day modestly lower, and bond prices gained, but only back to last week’s levels.

While low interest rates are designed to benefit economic growth, they have a negative effect on investors looking for safe ways to earn interest on their money. This adverse impact on conservative investors has not been sufficiently highlighted in the Fed’s ongoing decisions to keep rates at close to zero starting in 2008. Conservative investors have had to add riskier investments to their portfolios to try and earn even modest investment returns. While taking on this added risk has worked well since 2008, it still has its unsettling moments (as recently as August), and carries no certainty that the results will continue to be  favorable.

As the world’s stock markets continue to capture our attention with their extreme fluctuations, we think it’s important to present our view that most of this volatility is actually being created by traders, as opposed to long-term investors. (Note: this is our third memo in the last several days addressing current stock price declines.)

What’s the difference between trading and investing? Traders look to profit from price changes that occur in the short term, typically measured in days, frequently even shorter. The wider the price range, the more opportunity for gains or losses. Trading is a form of gambling, in that the result of the trade is known quickly and is often unrelated to any underlying, long-term economic rationale.

In contrast, investing presumes a lengthy time period, a set of goals to be achieved over that time period, and a view that there’s likely to be sustainable economic growth in the world’s economies over that time period. The investor’s relevant time period is measured in years, not days. We believe investors should not transform into traders when the markets experience periods of extreme market volatility.

A thoughtful article in The New York Times (August 22, 2015, pg B2, written by Ron Lieber), headlined “Take Some Deep Breaths, and Don’t Do a Thing,” makes the same point. Mr. Lieber observes, “Stocks are most useful for long-term goals. So unless these goals have changed in the last few days, it probably doesn’t make much sense to overhaul an investment strategy based on a blip of market activity.”

At Park Piedmont Advisors, we have long advocated that the U.S. stock market not be used as a basis for trading activity because trading can give rise to unsettling price changes from time to time. These changes can lead investors to take ill-advised actions that could undermine their long-term goals. Simply put, the financial well-being of long-term investors is threatened when trading activity turns the stock market into a casino.

Given the continued sharp stock price declines on Friday, August 21^st, and thus far on Monday, August 24^th, we’re sending this follow-up memo to discuss the pitfalls of alternatives to our customary advice of maintaining your current stock allocation. Our advice presumes that stocks are a necessary part of your investment portfolio to meet your long-term financial goals. The following is a list of the main alternatives, and the key issues associated with each:

1) Sell stocks and buy back at lower prices. This is referred to as “market timing”, and is very hard to implement successfully. In addition to deciding the right time to sell, you also need to make the right decision about buying back into the stock market. If you wait too long, you miss the upside that has historically come from the stock portion of your portfolio.

2) Sell stocks and hold as cash. Short-term cash/money markets pay virtually no interest in the current low interest rate environment, and are guaranteed to lose purchasing power to inflation.

3) Sell stocks and buy high credit bonds. Since interest rates are very low (with the 10-year US Treasury benchmark rate close to 2%), these bond prices are very high, and remain vulnerable to the anticipated rise in US interest rates (although issues in the world economy may delay the Fed’s raising rates).

4) Sell stocks and buy high yield income investments, from US and international issuers. When stock prices are declining because of fears of worldwide economic slowdown, these investments also tend to decline as credit risks increase.

5) Sell stocks and buy alternative investments that provide hedging opportunities. This is another form of market timing, because while hedges may help during stock price declines, they will also hold back the extent of the gains during stock price recoveries. Issues of timing include when to buy these hedges and when to sell them; if held for the long term, the hedging costs might result in a lower return than simply maintaining the initial allocation without the hedges.

6) Sell stocks and buy commodity investments like gold, oil, and industrial metals. Commodity prices have been declining in recent years, and continue to be adversely affected by the same economic slowdown that the world’s stock markets appear to be reacting to.

It’s no secret that both the Wall Street investment community and the media have an interest in convincing investors to increase their activity and market participation when prices turn down. At Park Piedmont, we’ve evaluated these various alternative strategies and concluded that your long-term financial well-being is better served by maintaining the allocations to the various markets that we developed with you in calmer times.  We’re available to discuss any of these topics in more detail at your convenience.

The past few days have seen sharp declines in US stock prices, but as of August 20, the S&P 500 stock index is down all of 1% for the year, and still above its January 30^th low by approximately 2%.  The current problems for the market range from slow world-wide economic growth; to more specific problems in China, and certain European countries ( eg, Greece);  to sharply declining commodity prices (which has a mixed impact on various countries, depending on whether they are primarily producers or consumers of commodities); to the likely beginning of interest rate increases in the US. Having stated the problems, it is important to note that none of them are new to the markets.

It is also worth noting that US interest rates on high credit bonds have declined modestly during the recent stock price declines, which means those bond prices have increased modestly.

As a context for the current stock declines, since the more than 50% declines that ended in March, 2009, the S&P 500 index has tripled in value (low of 677 to current 2,036). During this six plus year time frame  there has been only one period with serious stock price declines, from April 2011 through October 2011, when the S&P 500 declined  20% (1,362 to 1,100).  Since that 2011 decline ended, the index is up more than 80%.   Many of these historical figures can be found in our regular Monthly Comments.

In considering our message for the current stock price declines, we thought a repeat of portions of our August 2011 memo would be appropriate.

“We want to reemphasize our commitment to the idea that properly developed asset allocations, designed specifically for each client’s goals and risk tolerance, provide the basic rationale for not changing investments during periods of extreme downward market volatility….”

After presenting various figures, and a discussion of the problems of that time, we concluded as follows:

“As usual, we make no predictions as to whether these problems can be solved in a reasonable or timely manner. The future is always unknown. However, to the extent your financial goals require investments in what are by definition uncertain markets, we continue to advocate that your best defense is to maintain an asset allocation that allows you to get through times of high volatility without making changes that involve selling the poorly performing asset class.”

We would also add that it should not be surprising for stock prices to experience some period of decline, given the remarkable gains of the past six years.  There is no avoiding the investment truth that stocks can provide both significant gains, as well as uncomfortable declines. Trying to time these price moves we believe cannot be done consistently. Relying on your established allocation continues to be the best way to navigate the inevitable periods of downturns.