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Volatility – Opportunity or Cause for Concern?

May 15, 2018
by Jack Reynolds

Markets do not just go up. That is not the deal. There are market corrections – every year. We were spoiled for 18 months by a period of ultra-low volatility. I will focus on a few metrics with you to put volatility in context. More importantly, let’s explore the implications of the return of market volatility, including what you could consider doing about it.

Some investors see the return of volatility as scary, leading them to adjust their asset allocations, adopting a more defensive posture. Others argue that volatility is exactly what they have been waiting for, in that it affords long-term investors a new range of wonderful opportunities. There is a third possibility — that fears of volatility could become a self-fulfilling prophecy. We’ll explore that too.

NEPC (New England Pension Consultants) recently put it this way:

“Volatility roared back into US equity markets in the first quarter, snapping an 18-month benign streak. Stoked by fears of rising Treasury yields and a tumultuous unwinding in the short-equity volatility trade, the S&P 500’s[1] run of 15 straight months in the black ended in February.”[2]

Jamie Dimon, the CEO of J.P. Morgan/Chase has a slightly different spin on it, but he too sees volatility ahead:

“With the Fed paring back its balance sheet and the federal government increasing its borrowing, the U.S. will have to finance by the end of the year ‘$400 billion a quarter — that’s a lot, that’s a huge shift from the past,’ Dimon also said. Along with cutbacks in bond purchases by other central banks, it ‘may cause more volatility, higher rates in a way we don’t fully understand’ given the exit from quantitative easing is unprecedented, he said.”[3] (emphasis added)

Volatility is Normal

First, let’s ground ourselves on some metrics about volatility and market corrections:[4]

  • Good news: in 28 of the last 37 years, the S&P 500 has provided a positive investment return. That is a 76% hit rate.
  • Bad news: on average the S&P 500 has experienced an annual peak-to-trough loss of about 14% each year, even when the S&P 500 provided a positive return for the year.
  • In 2017 the intra-year drawdown of the S&P 500 was, amazingly, only -3%. The last time the S&P 500 had an intra-year drawdown of only -3% was in 1995 – 22 years ago. Those are the only two years since 1980 in which the S&P 500 has had such a small peak-to-trough loss.
  • Years of high volatility can also be highly profitable for investors who seize the opportunities offered by the markets:
    • In 2009 when the S&P 500 was up 23%, it also had a peak-to-trough loss of 28%. That was coming out of the Global Financial Crisis.
    • In 2003 when the S&P 500 was up 26%, it had a peak-to-trough loss of 14%.

Markets experience volatility, which is often driven by exogenous factors having little to do with the profitability of enterprises, the value of whose securities can be abruptly repriced. Domestic political and geopolitical events are two obvious factors.

Volatility is part of the function of markets. We all like upside volatility, but we tend to be less comfortable with downside volatility; however, that too provides important opportunities for patient, long-term investors prepared to take advantage of it.

Volatility Provides Opportunities

In listening to first quarter conference calls conducted by equity managers, I was struck by two very different managers making the same point: Volatility gives us an opportunity to acquire positions that we have been watching for months (and in some cases for years), at prices that we finally find to be attractive. We are long-term investors who are delighted by the opportunity to take advantage of short-term price movements. On the sell side, volatility gives us a chance to pare back, if not exit, more fully valued holdings when markets rebound.[5] [6]

For long-term investors, volatility is far from a curse. It can provide the opportunity that they require to buy low and to sell high.  It may, however, create challenges to the patience and commitment required for such a long-term strategy, which should be understood and analyzed explicitly.

A Possible Fly in the Ointment – A Potentially Self-Fulfilling Prophecy

As trading models become more mechanistic, rising levels of volatility can trigger reductions in equity allocations, thus serving to depress prices further. Value at Risk models embrace that concept, which models are often used by banks, insurance companies and pension funds in managing their investment portfolios.

Although some details of post-crisis banking regulations are under review in Washington and Basel, risk-based capital concepts push banks to adjust their portfolios and their lending in the same direction.  The same is true of Europe’s Solvency II directive. Further issues will arise as mark-to-market accounting is phased in; despite variations between U.S. GAAP[7] and IFRS[8], they both tend to go in the same direction.

These quantitative, risk-based, model-driven investment systems and regulatory regimes could lead to synchronous behavior, thus exacerbating a bear market in ways that have not been a part of prior market cycles to the same degree.[9]

What Steps Could Most Private Investors Take?

In the context of the foregoing, here are some steps that you might want to consider:

  • Be sure that you have enough highly liquid assets to meet your cash flow needs, including:
    • Living / lifestyle expenses,
    • Taxes,
    • Charitable commitments,
    • Foreseen/foreseeable commitments, e.g., children’s education, non-investment asset acquisitions,
    • Capital calls from non-marketable alternative assets funds to which you have made commitments, and
    • A reserve for unforeseen/unforeseeable expenses.
  • Review your asset allocation with your council of advisers, thinking about what risk means to you:
    • Permanent impairment of your principal,
    • Temporary diminution of mark-to-market asset prices,
      • What periods of temporary diminution or impairment are acceptable to you? or
    • Something else more personal to you.
  • How do you define what risks are acceptable or not: what goals make taking which risks worthwhile?
  • How do you view your risk profile?
  • Is your asset allocation suited to your risk profile?
  • If you don’t have a council of advisers, give some thought to assembling such a group
    • Keep in mind that asset managers are not necessarily the best advisers for these purposes, in part because they may be more comfortable with the specific risks that they live with every day than you are with those risks.
  • Review your asset manager choices with the same council of advisers
    • Periods of volatility can offer important opportunities for active managers to add value, so give some thought to your active vs. passive balance.
  • Review your financial plan and estate plan (preferably in that order) with a competent (preferably credentialed) financial planner and with your estate planning counsel in light of anticipated changes in overall volatility
    • Given the 2017 tax law changes, such a review is timely irrespective of an evolving investment climate.

In addition to the foregoing, please see the last section of my Nov. 2017 article  Asset Values Are Stretched – What to Do About it?, which articulates a five-pronged call to action for private investors.

Conclusion

Managing volatility is a part of the process of managing all of the risks in your portfolio and your broad financial/investment strategy. The steps outlined here and in my Nov. article (see link above) are intended to assist you with managing both volatility and other risks, including that of a potentially meaningful market correction, or other episodic event.

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[1] S&P 500 is an index of 500 stocks chosen for market size, liquidity, and industry grouping, among other factors. It is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large capitalization U.S. equity universe. It is not possible to invest directly in the index., although there are securities that strive to approximate its returns.

[2] NEPC 2018 First Quarter Market Thoughts, May 2, 21018.

[3] Bloomberg Markets, “Dimon Says Prepare for 4% Yields, Potential Volatility Rise,” by Stephen Engle and Chris Anstey, May 7, 2018, 9:53 pm EDT, updated on May 8, 2018, 7:05 am EDT.

[4] Source: Factset, Standard & Poors, J.P Morgan Asset Management, Morningstar Direct and Ballantyne Partners.

[5] Vulcan Value Partners (VVPLX) Large Cap Fund: 1st quarter 2018 conference call (C.T. Fitzpatrick, CIO, leading the call) – U.S. large cap value equity mutual fund, April 18, 2018.

[6] Chilton Flagship Fund: 1st quarter 2018 conference call (Richard Chilton, leading the call) – equity oriented long/short hedge fund, April 18, 2018.

[7] GAAP = Generally Accepted Accounting Principles. In the USA the Financial Accounting Standards Board (FASB) stipulates GAAP overall and the Governmental Accounting Standards Board (GASB) stipulates GAAP for state and local government.

[8] IFRS = International Financial Reporting Standards, which are a set of accounting standards developed by the International Accounting Standards Board (IASB) that is becoming the global standard for the preparation of public company financial statements.

[9] James MacKintosh, The Real Risk Is Believing That Volatility Is Risk, Wall Street Journal, April 30, 2018, published in the print edition as “The Real Peril in Believing That Volatility is Risk,” page B-1, May 1, 2018.