What Can We Learn from the Recent Volatility to Better Position Ourselves for What May Lie Ahead

Five Things You Should Know

1. Equity Markets – rebounded significantly this week with U.S. stocks (S&P 500) up 3.99% while international stocks (EAFE) rose 3.77% 
2. Fixed Income Markets – finished higher with investment grade bonds (AGG) up 0.55% and high yield bonds (JNK) up 1.19% 
3. Japan Recovery – Just a few weeks removed from the largest index drop since 1987 the Japanese stock market (Nikkei 225) has already recovered to its levels prior to their historic rate hike. Investors have shifted focus back to fundamentals and took advantage of cheap valuations, while BoJ governor Ueda will speak to parliament later this month and explain their decision-making to hike rates.
4. Fed Path Clearer – Another round of modest CPI growth this week further cemented expectations that the Federal Reserve will begin cutting rates in September. Now the debate becomes how fast of a pace the cuts will occur, with many now expecting a possible 50 basis point cut in September and 100 basis points before year end.
5. Key Insight – [VIDEO] This week we continue to explore how emotional reactions to volatility can derail a financial plan and offer some suggestions for how to work together to stay on track. [ARTICLE] This week Tim highlights four key questions that all of us should be asking ourselves with respect to our plans and portfolios after the recent market scares, as well as shares the data driving both the rebound in market’s todays, as well as the data that has many analysts still signaling caution for the market’s of tomorrow.

INSIGHTS for INVESTORS  

If you were fortunate enough to take a couple weeks of vacation to begin this month and truly checked out, you probably don’t know the market went through quite the temper tantrum to begin August with the NASDAQ index entering into correction territory, stocks declining in general and volatility spiking to levels seen during some of the hardest economic conditions of the last 20 years. This week alone has seen US equities make up the majority of those declines.

As market volatility abates for the time being and equities renew another run at new all-time highs, it could be tempting to pretend the moment never happened and hope it won’t happen again … tempting but not wise.

Rather investors should use the current calm to reflect on the recent bout of fear and ask themselves some important questions about what they learned, what they felt during, and how they could better be prepared, for the inevitable and unavoidable periods of market panic and related drawdowns that will occur in the future.

Here are some we suggest spending some time on:

1) Do you truly understand market volatility?

People will say they know that predicting the future in any way, let alone predicting market behavior, isn’t possible. They’ll admit that panicking during periods of volatility in the past has cost them in missed returns. And yet, when volatility spikes and all the associated fears and emotional responses, many people can’t help but engage in the very behaviors they know are counter-productive.

As the old adage goes, “market volatility is the price investors pay to make money overtime in the market.”

We’d call two key aspects of that saying, the first is that market volatility is inevitable. Consider again the accompanying chart from JPMorgan’s Guide to the Markets showing how intra-year drawdowns are the rule, not the exception and yet markets historically are still positive around 75% of the time.

The second key callout from that adage is the word “price.” Note it isn’t the word “fine.” As Morgan Housel analogizes in his book The Psychology of Money in Chapter 15 entitled “Nothing’s Free”, market volatility is better thought of as a price because people are used to paying for an experience or some form of returned value which markets have historically given to investors over time. However, what short-circuits many investors is the feeling that market volatility is punitive, like a fine, as opposed to an ordinary cost. The negative feeling associated with the idea of a “fine”serves to fuel the type of avoidant behavior that could risk causing investors to bail out during market turbulence costing themselves in any number of ways.

2) How did your risk tolerance feel when there was actual/perceived risk within the market?

As I’ve joked before, not that it isn’t true, investors cause their “gains” tolerance with their “pain” or risk tolerance. Of course, we all like to make money in the market and to that end would “take” as many gains as the market will give us, the issue is when the desire for gains[RB1]  does not match the associated pain/risk tolerance required to achieve those types of gains.

The test of one’s risk tolerance is not periods such as this week, or even the last year, but rather when the market is declining, and headlines are screaming tales of doom.

With that in mind how did you react to this most recent bout of fears? Did you take any emotionally based actions? Did you lose any sleep?

If so, it may be time to really dig into our next questions.

3) Are you properly diversified?

There can be short periods of liquidity crunches that send just about everything down for a period of time (i.e. March of 2020), but usually a well-diversified portfolio will have positions that can serve as a ballast against drawdowns.

Of course, the gains associated with momentum plays (e.g. most recently the tech/AI trade) are tempting to continue to allocate, or to this point over allocate, to but when the drawdowns happen there is no shelter from the storm.

As we’ve talked about a number of times over the last few months, now appears to be as good of time as any since the Great Financial Crisis to be a diversified investors with both good return potential as well as risk mitigation from fixed income and alternatives.

Have you allowed yourself to be pulled in from the siren’s song of the momentum trade, or did you find yourself with some nice performers during the most recent selloff?

4) Are you properly structured?

To have your portfolio L.I.V.E. to its full potential in light of your personal story you need to follow its outline. Most notability address your Liquidity and Income needs (the first two letters) of the acronym to fully enjoy the latter, either reduced or acceptable Volatility and the corresponding Expected Returns you hope to see over time.

To that end, when the markets were selling off and headlines screamed of the impending recessions, did you find yourself questioning or concerned about potential cash flow or ample liquidity for near to intermediate term needs? If so, adjustments are certainly in order.

Expected Returns are of course wonderful, but nothing short circuits them faster and/or can create truly dangerous scenarios that too much leverage and risk, mixed with insufficient cash and liquidity to allow your return vehicles the time they need to perform.

The Current Outlook

This week brought some good data points that for the time-being have pushed markets meaningfully higher.

The first and most important for markets was the latest CPI reading that came in at +0.2% for July and +2.9% year over year. Such a reading is viewed by most as giving the Fed clearance for at least a 25-basis point (0.25%) cut in their rate at their September meeting.

As to the markets second concern that was behind much of the recent worries, whether or not we are headed toward a recession, two big data points seemed to suggest that if we are headed to a recession, it isn’t as imminent as was feared.

The first such data point this week was the latest jobs data which showed that there was a second straight week of declines in applications for US unemployment benefits as well as declines in recurring jobless claims. While the second such data point was Retail Sales, which came in +1.0% in July, versus expectations for a gain of only 0.4%, suggesting the health of the US Consumer is much better than feared.

However, despite how the markets may be reacting this week not all data is signaling the “all clear.”

One negative data point to keep an eye on was July’s Industrial production print which declined 0.6% in July along with meaningful downward revisions to prior months, as well as declines in capacity utilization.

Furthermore, market technicals and other quantitative metrics are signaling caution.  As to the former, Jeff deGraaf of Rennaissance Macro noted a number of “dark cross” signals for various parts of the market (a dark cross is where near-term averages drop below longer-term averages). While also noting the weak seasonality of this time of year he stated, “What is coinciding with this rally is a dark cross in high vs low beta, a dark cross in cryptocurrencies, and a dark cross in the IPO-SPAC index. All are forms proxies for risk and each is a unique proxy for overall liquidity. Whether this is a hang-over from Yen carry or simply the result of the +130bps spread between Fed Funds and 2-year paper is impossible to know, but it is different from the conditions at any other point this year, and that makes us more cautious than usual. We’re still in an uptrend on the SPX, so be respectful, but here at resistance, shaving a little off the top is our play.”

Looking at some quantitative analytic points Charles Gave, of Gavekal Research, pointed out some concerning disconnects between the ratios comparing the S&P 500 to Gold, and the S&P 500 to Oil. Regarding the latter, he states “The ratio which is totally out of whack is the S&P 500 valued in terms of the price of oil. Currently, the US stock market is priced as if WTI were at US$50/bbl, whereas it is actually at US$77/bbl. In contrast, the current price of gold (the prices of gold and oil always converge eventually) suggests that WTI should be at US$100/bbl, plus or minus US$10/bbl. So, it appears that the stock market is expecting a significant decline in the price of oil. I have no idea whether this expectation is right or not, but I do have an idea what would happen if the price of oil were to go up instead of down … in the last 100 years, the ratio of the S&P 500 to WTI broke below its seven-year moving average on around 10 occasions. Each time, this was a sign that the economy was failing to transform energy profitably. And on each occasion, the Shiller P/E went down. Each of the four Ursus magnus bear markets—in which stocks fell by more than -40%—took place in one of these periods. The current anomalous pricing of the S&P 500 relative to oil suggests that US stock market movements in the near future will be extremely sensitive to any rise in oil prices. I will go as far as to say that the only thing that will matter over the next 12 months will be the relative movements of the S&P 500 and the price of oil.”

Given the current geopolitical outlook the risk to oil prices would seem to be to the upside, thus signaling caution to the US economy and equity markets.

In Closing

The time to evaluate the wisdom of your approach from asset selection to allocation is not in the midst of market tumult, but before such a storm even begins.

If there is anything to be gained from going through the recent market volatility it is to seize the moment to reflect on the emotions and thoughts you had earlier this month before they abate in the background to make the necessary adjustments for when it inevitably returns.

While many data points suggest the recent fears were misplaced or early, there are others that suggest such concerns may be back before long.

We review and frame the data not to better predict, but to better prepare both emotionally as well as structurally within our portfolios to reduce the emotional toll/price to be paid during tough markets, while also better positioning ourselves to more fully realize the returns we hope to experience overtime.

As always, we are here to help talk through any of this with you or those you care about anytime.

Have a wonderful weekend,

Tim and the team at TEN Capital

DATA, JUST THE DATA

U.S. PPI – increased 2.2% YoY in July of 2024. This eased from an upwardly revised 2.7% gain in June and was below market expectations of 2.3%. 

U.S. Retail Sales – soared 1% MoM in July of 2024. This followed a downwardly revised -0.2% drop in June and was much better than the forecasted 0.3% gain. 

U.S. ISM Serices PMI – rose to 51.4 in July of 2024. This was above market expectations of 51 to indicate a moderate rebound in US services activity. 

U.K. PPI Input – decreased by -0.10% in July from -0.40% in June of 2024. 

Eurozone Industrial Production – decreased 0.1% MoM in June of 2024. This missed market expectations of a 0.5% rise and after an upwardly revised 0.9% fall in May.