The cruise ship sank. The passengers are gathered in the lifeboat. The officer in charge knows how to reach safety, just over the horizon. If the passengers trust him, sit in their seats, pull on the oars and bail when necessary, all will make it home. The problem is one passenger, let's call him Mr. CNBC-FOX-CNN-MSNBC, who is a hysteric.
If the waters are calm, he'll focus on other issues (ISIL, Ebola, the mid-term elections, where is Kim Jong Un?) But the moment some waves hit the boat, he panics and starts jumping from one side to the other of the lifeboat. As he thrashes, other passengers panic with him. Soon the whole lifeboat is rocking side to side (up 1.7% one day, down 1.9% the next day.) If the rocking becomes violent enough, some passengers may decide to jump out of the lifeboat and try to swim for shore by themselves (we don't go back for those passengers.)
We're surprised less by the recent volatility, surprised more that markets have been so calm over the last three years.
Portfolio-Level Performance Disclosure
The portfolio-level performance shown is hypothetical and for illustrative purposes only. Investor returns will differ from the results shown.
The benchmark is 80% S&P 500/20% Barclays Aggregate Bond index.
So many horrible things happened over the last 15 years. Yet, if you invested $1 million in index funds (80% S&P 500/20% Barclays Aggregate Bond Index) on January 1st, 2000 right at the start of the "decade of suck," you'd have $1.8 million. If you had invested the same $1 million in a broad basket of off-the-shelf mutual funds, 80% stocks/20% bonds but broadly diversified to include international developed and emerging stocks, REITS, commodities and preferred stock (and paid an advisory fee of 0.75%/year), your portfolio would grow to over $3 million (after deducting an advisory fee of 0.75% but before deducting taxes.)
In the last 15 years, we saw:
- Internet Bubble bursts
- 9/11 Attacks
- 2002 Recession
- Housing Bubble inflates and bursts
- Bear Stearns fails
- Lehman Brothers fails
- Great Recession of 2009, and March 2009 stock market collapse
- Greece fails once
- Greece fails a second time
- Italy and Portugal nearly default
And then, most curiously, a three year stretch through August 2014 where the US Stock Market had almost no volatility at all. Since no media outlet can remember events of more than 6 months ago, the recent return to NORMAL volatility is headlined as "The End of the World!"
We tell our prospects, "We're reasonably confident MORE horrible events WILL happen over the next 15 years. But we're also reasonably confident your money will double, possibly triple in the same time frame - why wouldn't you take that bet?"
The reason why investors DON'T take the bet is because our national media is dedicated to scaring you silly every day. If it's not stock market volatility, then you should fear Islamic terrorists, Russian hackers in your bank account, West African diseases coming through the airports, South American children swarming the borders of Texas and New Mexico.
Here's the deal. People who work for General Electric or McDonald's or Pfizer watch the same bad news as you. And then these employees go to work every morning to build better turbines, or better hamburgers or better Viagra, or they don't get paid a salary. And thus corporate revenues grow, thus earnings, thus stock prices, thus our clients' portfolios.
The third of our clients who are retired and dependent on their portfolios for their lifestyle continue to receive their monthly draw without fail. How? Because we have a year's worth of retirement income in "near cash" investments and four years of income in bonds. We reload the cash and bond buckets a couple of times a year from the "risk bucket" which contains US, international stocks, and commodities. If, as we saw in 2009, the "risk bucket" collapses in value, we simply suspend the transfer until risk asset prices recover. We have NEVER reduced a clients' monthly draw in the 20+ years we have run this firm.
The Short Explanation of Current Volatility
US stocks have come far and fast in recent years - 202% since the March 2009 low, 39% since January 2013. Investors raised cash to purchase Alibaba stock last month by selling stocks that did very over the last 5 years. The temporary downturn caused the "weak hand" investors to sell additional stock through the end of September, while other investors booked profits coming into quarter end. The magnitude of the recent pullback of the same magnitude as NINE OTHER pullbacks over the last three years. Each time, stocks moved to new highs within a month or two.
We would totally EXPECT the market to "back and fill" for a few months given the age of the current bull market. Fed policy STILL remains accommodative with interest rates STILL at multi-generational lows. Inflation STILL remains contained at 1.5-2%. The employment rate continues to drop, now 5.9% (yes, the labor participation rate is still too low, but the US economy will add 2.4 million jobs this year.) 2nd Quarter US GDP was a blistering 4.6%, reversing Q1's decline of 2.1%. On a year over year basis, the US economy is growing at about 2.2%, which is on the low side, but also means no risk of inflation. More good news for inflation - energy prices are down sharply with oil at the lowest level in two years. Gas station prices will fall in a month, throwing extra cash consumers as we head into holiday shopping.
Our biggest concern is that earnings growth is in a lull right now, with Q3 2014 numbers to show only 1.5% growth year over year. For much of the year, the median stock price traded about 5% above Morningstar's fair value estimate. With the recent pullback, stocks are now at 2% discount. We would need to see stocks trading 10% above fair value to cut back positions, or 10% below to buy aggressively. At present, we are simply rebalancing accounts in line with our target allocations.