The first week of January was the worst on record. The S&P 500 index fell by -5.96% to close at 1922. The index is now back in September 2015 trading territory.
It was an brutal week, no doubt about it. However, if you’re my client, then you know that this decline did not catch me by surprise. I’ve been expecting a market decline since last summer. This defensive allocation has certainly helped limit this week’s downfall, outperforming nearly all of my competitors portfolios. Here is how my portfolios have performed this week (real returns).
Watching a portfolio decline in value is a very uncomfortable feeling for anybody. This is especially true for me. As Rob Arnott has famously said, “(W)hat is comfortable is rarely profitable.” In my opinion, the most important responsibility I have as a portfolio manager is to preserve and increase the real wealth of my clients. To accomplish this, most portfolio managers look at areas of growth and opportunities first. I believe this is the wrong approach as these portfolio managers often expose their capital to many hidden areas of weakness. I prefer to focus first on risk levels in the different markets. If an asset class is vulnerable to higher than average levels of risk, then my job as a portfolio manager is to reduce that exposure. By employing this simple rule of thumb approach, I am able to avoid a lot of the “unforeseen” market turmoil.
Of course, as with anything in life, no one can ever have 100% conviction in any single idea or approach. This is especially true within the stock, bond, and alternative markets. This is why I weight my conviction by looking the probability of an any likely outcome. Right now, in my professional opinion, the probability of lower economic growth here in the U.S. is high.
Many indicators over the past year have been showing signs of stress (e.g. widening credit spreads, small caps underperforming large caps, end of QE, slowing developed markets, the Chinese slowdown, burgeoning margin debt, etc.). I have been writing about this for quite some time, so it is no big secret to those that know me.
Where do the markets go from here? I honestly do not know. But risk levels have yet to decline. Additionally, the market selloff is likely not yet over. We have yet to see complete capitulation where the everyday investor has completely given up. There is a pattern that seems to always occur within the financial markets:
- We are near a market top when: Investors extrapolate recent market returns out into the future (what has been going up will continue to go up indefinitely). Of course, this is false and it leaves markets overbought.
- We are near a market bottom when: Investors that have lost money in a declining market give up completely, especially when those losses seem insurmountable. When your neighbor or co-worker tells you that investing in the stock market is for fools, then you know we are near a market bottom. Another favorite and non-scientifiic signal that I look for are front page articles (web and print) that portrays the stock market as an ugly, nuclear wasteland (or something similar). This gives the impression that investing in this market is financial suicide. Famed value investors, of course, buy at these moments.
We are only -10% from the market top and we have yet to see investors give up completely. While this was an ugly week on Wall Street, a correction requires a further drop over time. Furthermore, the US stock market is still relatively pricey. My intent is to stay patient and defensive until there is a better opportunity. Investing is a marathon, not a sprint. Those with a long-term view always wins the race. Finally, I will leave you all with a quote to help keep things in perspective: “The four most dangerous words in investing are: ‘this time it’s different.’” (John Templeton)