To Be Worried, or Not To Be Worried, That is the Question.

I am not worried about Friday’s 666-point drop of the Dow Jones Industrial Average (DJIA). I feel better about the health of the market with the past week’s retreat than I would otherwise feel had it not occurred. Taking a bit of pressure off of a rapidly heating market is not a bad thing. But people tend to worry. Or at least people tend to express concern. I did field a lot of calls and messages on Friday. The great thing about calls and messages from clients was that they were all reasonable, even-keeled, and well-informed. That makes me feel great about the work I do with clients, or at least feel great about the way clients feel about the work I am doing on their behalf. Calls and messages coming from folks that are not clients? Not quite so reasonable, even-keeled, or well-informed. If for no other reason than times like these, I wish everyone would, or could, work with a professional advisor.

So I had an internal debate raging all weekend. Should I comment publicly about the market’s weekly decline? Should I let it slide as normal market behavior, comfortable that Lake Jericho clients “get it”? Honest client concerns aside, it has become increasingly difficult to tell when some folks are genuinely worried about market conditions versus when some folks are simply glomming to market conditions as a type of political wedge. Thus the internal debate; what are Lake Jericho clients, my friends, my family, truly concerned about, versus what is it that I see in market sentiment that is just hyperbole, and what, if anything, should I state professionally?

First, my primary concern is with Lake Jericho clients. And to address client concerns, why am I not worried? Easy answer. Perspective. Some investors are focusing on the eye-popping 666-point, one-day decline alone. Humans are built of inherent biases, mental short-cuts, among which is our conditioning to evaluate absolute numbers quickly and short shrift the relative analysis. It is a type of anchoring bias in which we hear a number and react, often without an appreciation for what the number itself might currently mean. Headlines (or Facebook posts) fuel those biases, shouting “worst day since Brexit”, “biggest weekly drop in 9 years”, “my 401(k) lost thousands”. But the headlines are intended only to grab your attention, not intelligently inform. So the headlines flame feelings, people seek no further insight, and all perspective is lost. In proper historical perspective, the Brexit impact reversed in less than 48 hours, the DJIA has doubled in 9 years, and it is likely that your 401(k) has far more than doubled in recent years. Absolute headlines are not reflective of relative experience.

So let us add some perspective. When the DJIA dropped 508 points on October 19, 1987 it amounted to a drop of 22.6% on one day. When the DJIA had its worst single-day decrease of 679 points on October 9, 2008 in the midst of the nation’s financial crisis, that was a 7.3% one-day drop. By comparison, Friday’s 666-point drop was a 2.5% decrease because the absolute value of the Index has climbed so much in the post-crisis recovery. For the week, the DJIA declined 4.1%, the S&P 500 shed 3.9% from its all-time high last Friday, and the Nasdaq Index fell 3.5%. To geek out on the statistics a bit, with a 10-year standard deviation of 14.2%, Friday’s 2.5% drop might be less-than-common but it certainly should not be considered abnormal. What has been abnormal is the lack of meaningful pullback during the past 18 months. When last week opened, the market had run 400 days without a pullback of 5% or more. Friday’s 2.5% drop should be taken more as a sign of return to normalcy than a worrisome deviation from the norm. Even so, one trading day does not mean that the nine-year bull market in stocks is dead.

A 100-year history of the Dow Jones Industrial Average: 

When we picture last week’s move in historical perspective, we can see that it is hyperbole that drives our perception. In reality, Friday’s move barely registers on the scale of  historical volatility.

A graph of a 100-year history of the Dow Jones Industrial Average

100 Years of Daily Moves in the DJIA: Source Macrotrends

Second, and as I’ve been saying in quarterly Recap’s for a while, the fundamental factors that have driven stocks higher — improving global economic growth and rising corporate earnings — remain intact. It is widely expected that corporate earnings will continue to grow by double digits, especially now that the U.S. tax reform plan has cut the federal corporate tax rate to 21% from 35%. Market internals (those measures market professionals use to evaluate the health of markets themselves) showed no signs of panic selling. General market consensus, and our own internal view, is that this pullback represents a good buying opportunity rather than a reason to sell. And buy, where able, is exactly what we were doing on Friday.

Third, about hyperbole and political wedges? I mention the third-rail of politics in this discussion because one can hardly assess market sentiment these days without a grasp of the narratives that drive particular views. If it is true that politics makes for strange bedfellows, then it must be true that objectivity about politics makes for no bedfellows at all. But if I can’t be objective, then I cannot do my job. I am fond of saying that “the truth is typically somewhere in the middle”. Given the tribal polarization of media coverage today, that saying has rarely been so true as it is now. To properly evaluate current market conditions, I must filter out the biases and objectively evaluate facts. It seems that if I am widely reviled by both sides of the political spectrum, then I am capably doing my job. I encourage everyone else to attempt the same.

So what is happening? Why did Friday happen? If you will recall from Lake Jericho’s Q4 2017 Recap posted just last week, we speculated that were there to be a metaphorical fly in the ointment of this market that it would come in through the window of interest rates, currency rates, or commodity values. Last week’s main sell-off trigger was growing concern about inflation rising more quickly than expected and therefore interest rates more rapidly increasing, and both of their impact on stock values going forward. The economy’s growth already has pushed up market interest rates. The yield on the U.S. Treasury’s 10-year note hit 2.84% on Friday, its highest level since 2014. Lake Jericho has defensively positioned client accounts against gradual movement higher for some time. Rapid, unanticipated movements in rates are exceedingly difficult to defend against.

Concerns about rising inflation and a corresponding increase in interest rates were heightened by the Labor Department’s U.S. jobs report released Friday showing the largest year-over-year percentage gain in average hourly wages, 2.9%, since June, 2009. The report also showed sustained low unemployment in January at 4.1%, and that employers added 200,000 jobs last month. All of that data further fuels the narrative that inflation is picking up. This has always been the market’s concern with the Trump administration’s myriad of pro-growth strategies; though enthusiastically welcomed by corporate America and investors alike, it might simply be too much and lead to overheating of the economy. Rapidly rising inflation could lead the Federal Reserve to move more quickly in lifting interest rates to keep inflation in check. Increases in interest rates puts upward pressure on business and consumer borrowing, where rates could trend higher for home mortgages, auto loans, business loans, and other personal and business big-ticket purchases requiring debt financing. Despite rising corporate earnings, rapidly rising interest burden costs could offset those gains and cause investors to rethink the long-term value of the stocks they own. Further, if interest rates in the U.S. were to increase at a faster rate than those in other developed economies around the world, a resulting impact could be a rapidly rising value of the U.S. dollar. A stronger U.S. dollar could also negatively impact the earnings of large, multinational U.S. companies as they translate those earnings back into dollars. A stronger dollar could also make it more difficult for smaller U.S. companies to sell goods and services overseas.

To wrap all of this up in a tidy little package, I will remind folks of stuff that I talked about a great deal during late 2015 and early 2016. The predominant theme then was that as markets adjust to new or changing expectations there will be price dislocations and market distortions. The market is wise and all-knowing, but it takes a while to figure itself out in the light of new information. This past week has been a process of assimilating new information. What we experienced was natural volatility. And frankly, a return to some natural volatility that we knew would be coming back eventually. As I said in the Q4 2017 Outlook, I see nothing yet on the near-term horizon that meaningfully changes my expectations. I expect to see last week’s volatility fall a bit throughout Monday’s market and settle lower into Monday’s close. If this happens, it will prove to be an excellent opportunity to put more money to work. If I am wrong, and volatility continues to increase during the week then we will have a different set of decisions to make.

Regardless, rest easily knowing that I am watching all of this and ready to act when necessary. If necessary.

A.J. Walker, CFA CFP® CIMA®
Founder, President, and CEO
Lake Jericho, LLC

3rd Quarter 2015: Quarterly Recap and Near-Term Outlook

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