The thing about the 3rd quarter of 2015? There was a little something for everyone to dislike. Markets across nearly all sectors were beat down, particularly in September. Even broadly diversified investors, historically able to find some shelter in lower-correlated sectors, were left with nowhere to hide as practically all major asset classes had significant losses for the quarter. Large-company U.S. stocks were down, and small-company U.S. stocks were down double-digits. Developed international markets were also down, off just over 10% on average with some such as Germany down in the neighborhood of 20%. Emerging markets were simply crushed, down nearly 20% for the last three months and continuing a multi-year slide. The U.S. energy sectors continued to slide as well. Longer-term U.S. bonds as measured by the Barclay’s Aggregate Bond Index were a bright spot up 1.23% for the quarter, but were a dicey wager in light of interest rate uncertainty in the U.S.
As investment professionals we could barely absorb unsettling information from one area of the investment marketplace before another cycle of news from a different space would rise to the headlines. It was a lather-rinse-repeat type of quarter in which a sure-footed basis for certain investment valuation was difficult to find. Take particular note of my choice of the word “valuation” rather than the word “pricing”. I’ll get to the “why” of that choice quickly. But until then take your pick of the investment news headlines of the past quarter:
- a “kick the can down the road” short-term resolution of Euro-area pressures caused by the Greek debt crisis,
- concerns over slowing global economic growth potentially indicated by the sudden devaluation of the Chinese currency,
- continued strengthening of the U.S. dollar against other world currencies, potentially making U.S. produced goods and services less attractive in foreign markets,
- a continuation of the years-long trend of slowing economic growth in emerging markets,
- the perpetual wait-and-see approach of the U.S. Federal Reserve towards interest rate normalization in the U.S.,
- short-term earnings pressures on the global energy infrastructure as the world awaits realization of long-term benefits of reduced energy expenditures on other sectors of the economy,
- tone-deaf hedge-fund managers so dramatically increasing costs for medications that a shift to increased government regulation of pharmaceuticals and biotech becomes increasingly possible,
- corner-cutting and unethical behavior by the world’s largest automaker single-handedly dragging down a leading industrial economy’s stock market to a 20% correction.
What is it that each of these headline items have in common? Each of these items injects into the investment marketplace a heightened level of economic uncertainty. In many aspects, uncertainty in the investment valuation arena is much worse than certain, but unquestionably bad, news. There exists an unattributed quote “price is only ever an issue in the absence of value”. The 3rd quarter was somewhat a manifestation of this idea. When increased uncertainty is injected into the process of valuing an investment, smart investors typically do the smart thing (nothing). During these periods of heightened uncertainty smart investors (and analysts) revisit their valuation models, carefully examine the inputs to those models in the light of a broad range of potential inputs and possible outcomes, and only then patiently execute any change to long-term strategy. Conversely, not-so-smart investors fall prey to the instinctual need to avoid volatility (and of course only the downside volatility) and sell. Not-so-smart investors ALWAYS sell too late, almost always sell at the worst possible time, do so in a panic, and will do so at any price that they can get. As Warren Buffett says, if you want a deal badly enough you are sure to make a bad deal. Panicked investors are driven by instinctual behaviors to drive markets, irrationally, lower.
Admittedly, a fundamental tenant of economics is that the only value of something is the price someone is willing to pay for that thing. Ok, fine. But that also assumes there exists a willing buyer and a willing seller. But if we aren’t selling, then what do we care about someone else’s price? That other person’s price might be reflected on a report we receive or on our screen when we log into our account, but practically it means little to the long-term intrinsic value in our long-term investment. In the end, cooler heads always prevail and the smart investors have waited for greater clarity to present itself before finalizing any revaluation, and certainly before making any trading decisions.
It is this type of sure-footed basis for investment valuation and trade pricing that puts a floor under every market’s downside volatility. Smart investors are rewarded for their patience. While the global economy outside of the U.S. is showing signs of current softness, most major U.S. economic data is comfortingly positive. The jobs market continues to improve as the unemployment rate continues its slow, but very steady, downward trend (currently at 5.1%). The average U.S. consumer is doing well as indicated by The Conference Board Consumer Confidence Index®,. We are seeing consumer-focused signals of the positive effects of lower energy prices. Rapid deleveraging after the 2008 recession and sustained low interest rates have resulted in the average U.S. household using less income to make debt service payments. These trends have likely contributed to auto sales from most major manufacturers reporting results well above forecasts. The U.S. construction economy, including residential building, again showed signs of strong growth. And remembering that everything is cyclical, an improving U.S. consumer situation, a stronger dollar, and lower commodity prices may very well lead to increased consumption of goods manufactured in China (an area on which an undue amount of attention is spent). We maintain our basis for forecasts of net-positive gains for 2015. And in fact, the first days of the 4th quarter have provided much needed relief as markets have recovered meaningfully from the lows of the 3rd quarter. In many cases, more than half of the territory lost was quickly regained in the past week.
As I have stated, and will continue to restate, Lake Jericho is an investment firm with a long-term focus. We are not a trading firm that seeks short-term or speculative profits for clients. We understand that “risk”, if defined simply as price volatility, is not a bad thing to take in our investment portfolios. Without risk, there can be no reward. So at Lake Jericho we measure, and carefully manage, the amount of and the price of the risk we assume for client portfolios. While we concern ourselves with daily price fluctuations of the market to inform our decision making, clients should take comfort in our capability to differentiate between what is true change in long-term value prospects and what is behaviorally driven short-term pricing changes. Each of you can expect to receive your account-specific quarterly statements in the coming days. We are available at any time and any day to discuss specific portfolio performance.
A.J. Walker CFP® CIMA®
Founder and Senior Consultant
Lake Jericho, LLC