Watching the Storm Through the Window

Good afternoon,

If you read the newspaper, listen to the radio, or watch TV, you can’t avoid hearing about the current tumult in global markets. And yes, there is no denying a fundamental change in market behaviour over the past few weeks. Per the chart below, Canadian (red) and international (green) stocks are down over 10%, and US (dark blue) stocks are off 7% since their peaks in late August and early September of this year. Of course, when investors are uncertain and start to abandon stocks, many flock to government bonds for safety, and the current period is no exception. Note the strong returns to US government Treasury bonds (light blue and black) while stocks have been crashing. There is always a bull market somewhere, and our investment models are built to find it.

Source: Stockcharts 
Since everyone wants a plausible narrative about what might be causing this shift in sentiment, we offer the following three options and invite you to choose the one which most resonates with you:
  1. Markets are contemplating the implications of the impending withdrawal of regular monetary stimulus on the basis of recent guidance from the Federal Reserve. It was the Fed’s stated goal to effect a broad rise in asset prices after the Global Financial Crisis five years ago through Quantitative Easing. The market is wondering where asset prices might find equilibrium once the Fed removes the punch bowl.
  2. Europe is experiencing its third potential recession in the past 5 years, with important economic indicators out of the region’s strongest economic centre coming in much weaker than anticipated over the past few weeks. In addition, European inflation indicators are flirting with deflation while the European Central Bank has been all talk and no action.
  3. Markets have accumulated a large amount of instability over the past few years as investors have piled on leverage and margin in order to capitalize on stocks’ seemingly invincible rise. Minsky modelled how long periods of stability breed high levels of instability, just as long periods without large forest fires leave forests vulnerable to ever larger blazes once the match is struck. We may have reached Minskyan criticality, where a small tremor was enough to start a large avalanche.
Of course, as we write this note, representatives of the Federal Reserve are already publicly discussing a new round of stimulus, and addicted stock market investors are crowding around with their palms out waiting for more monetary methamphetamines. We have no idea whether the Fed will continue with its plans to wean markets off the powerful stimulants its been doling out over the past few years, or whether it will capitulate under market pressure. And frankly, it doesn’t matter, at least from the perspective of investment portfolios. Our model portfolios continue to demonstrate the power of adaptation and risk management, and we have no reason to believe future markets will be any different.
Speaking of portfolios, clients will be pleased to hear that our models detected this shift in markets at the beginning of October. As a result, portfolios were rebalanced to include about 80% exposure to safe harbour U.S. government Treasury bonds. The model also indicated that a 20% position in U.S. stocks should be preserved in case the current crisis also turned out to be a false alarm. As it stands, stocks and bonds contribute approximately an equal amount of risk in the current portfolio, which means we are very well balanced at this time against either an exacerbation or a reversal. Given the exceptionally strong performance of Treasuries however, managed portfolios have eked out small positive returns this month. Which is what we would have expected. 
At times like these, it is helpful to reflect on why we decided to invest our hard earned savings in such a novel way. Recall the times when you felt frustrated at the perceived lack of progress in your own portfolios while markets rocketed higher, and commit to remembering times like today, when markets are storming while you watch through the window from your comfortable perch by the fire. The future will hold many more periods of relative frustration and joy. The secret to success is to recognize these experiences for what they are: a rich part of the human experience, which is separate and distinct from the decision making process. This recognition will allow you, with practiced thoughtfulness, to maintain the discipline necessary to reach your financial goals. 
As always, if you have any questions or concerns, or if you know someone who is concerned about their current portfolio, please do not hesitate to contact us. We are at your service. 
Warm regards, 
Your Butler|Philbrick|Gordillo & Associates Team