The risk that stalks us all

"Volatility is not risk. Risk is the permanent impairment of capital." ~Rick Rieder

What frightens you more: sharks or mosquitoes? The statistical answer flies in the face of the average response. It’s a near-perfect example of how most of us think about risk; manage our fear; stats; and how we make decisions. We choose not to surf or swim in waters where a rogue shark was sighted weeks or months earlier, but we’ll traipse through a jungle hike without proper netting or the safe application of repellent. The truth is we’ve all watched Shark Week one too many times. It’s stories versus statistics. (Maybe if they had Mosquito Week we’d change our tune). Statistics are useful to the extent that we find their insights more persuasive than anecdotal stories. Problem is, we often don’t. Same thing happens in the stock market. Because of technology we are all intently aware of each market wiggle and the conjecture that comes with it. It’s the investor version of constantly watching Shark Week. Volatility is scary and can keep you out of the water. Yet the mosquitoes, i.e., the higher risk statistically, is often our own behavior around this volatility. It constantly lurks in the shadows somewhere near us, stalking our psyche, ready to strike the moment we let our guard down. And yet ironically it's probably the risk that is most easily ignored and underestimated when thinking about our investments.????

Look, markets freak out from time to time. But as investors it’s important to remember that every time stocks fall it doesn’t mean the world is coming to an end. Historically speaking, there have been big market drops and corrections in both secular bull and bear markets alike. Since WWII we’ve had 40 double-digit draw-downs, give or take, in the stock market. That amounts to one every 14 months or so. The median draw down is around -13.3%. Statically speaking (>60%), most often these drops do not turn into a full-fledged bear market. Sometimes, sure, but we simply cannot know which ones will … I certainly have no edge in guessing here. I do however have strong research-based opinions loosely held, but this is vastly different from being able to predict short-term market moves. Regardless, this whipsawing is what markets do; returns aren’t free. And this is primarily why investing is hard. It tests your emotions, your mettle. It tests your conviction, your patience. It tests your belief in a better tomorrow (to wit, Ben Graham once wisely said “to be an investor one must believe in a better tomorrow”; I absolutely agree).

As Ben Carlson keenly observes - "risk and return are attached at the hip when it comes to investing. Unfortunately risk does not guarantee that you’ll see a decent return on your capital but it is a prerequisite that you must bear risk in one form or another to earn returns." For stocks, the biggest “risk” is that they can go down – sometimes by a lot. So the “price” we pay for the superior returns in stocks is a psychological one that comes from inherent and, often harsh, volatility. To be clear volatility is a feature not a bug of stocks and itself is not “risk.” Rather, the chance that one panic sells at the wrong time in a down market thus taking them out of a game that offers them the opportunity to capture extra return over the longer-run?is risk. In my mind’s eye I like to think of?volatility as the normal ups and downs of a roller coaster, but risk as the prospect of a rider losing their nerve causing them to unbuckle during the ride then bailing off before it ends. If you hang on and see it through, odds are you’ll probably be OK. Same with stocks. And it’s imperative that you stay in the game.

I share all of this because we are *obviously* now going through a period where wild market swings and punditry (i.e., the noise) are making us “earn” our long-run returns; returns that encompass both good and bad markets. I encourage you to think of market volatility in this way. Not as, 1) is this the start of the next recession? And also not as, 2) is this the beginning of something so much worse, the next bear market or next crisis?

On the first concern, historically the stock market is quite bad at forecasting economic recessions with a median return of +11.6%, +1.2%, and +1.0% at 12-, 6-, and 3-month intervals, respectively, prior to recessions going back to 1928. (This is probably why Paul Sameulson once quipped that stock markets have predicted 9 of the past 5 recessions). Flipping the issue around, while bear markets don’t predict recessions they do typically occur inside of one. In fact, going back to 1945 roughly 90% of all bear markets developed in this way. As such, in a moment I will share high level, and as crisp as possible, my reading of the current economic information insofar as it contextualizes the current environment and helps answer questions when asked to wax economical.

Addressing concern #2, again, though stocks falling can often feel like a presage of the next bear market the preponderance of data tell us it’s not a high probability outcome. Clearly every bear market begins with a -1%, -5%, and -10% drop. But not every drop is the beginning of a bear market.

Instead, think of volatility as, right now stocks are making me work for / earn my superior payoff many years down the road. The delayed gratification gene is a hard one to summon during times of stress, but it’s one that holds the highest odds of allowing you to make the best decisions over time. Psychologically the long-term is an abstract concept far off into the future. But we live life in the short-term, in the here and now. And the reality of this human experience can lead us to behave in ways today that aren’t in the best interest of our future selves. Jerry Seinfeld once did a comedy bit called “Night Guy” that is pretty funny and I think perfectly captures this bias we all have. It’s a pervasive behavior in our lives, and a great analogue for investor know thyself.???

"It ain't what you don't know what gets you into trouble. It's what you know 'for sure' that just ain't so."?- Mark Twain

Amid downside volatility the questions we often all get (both internally and externally) go something like this: “why is the market down?” / “what is causing the sell-off?” / “what information is out there that will help me understand what’s happening?” The desire to ask these questions and hunt for answers, for certainty, to explain the discomfort we feel during market draw-downs is completely understandable. We are cognitively wired to seek out answers because if we can identify the cause then perhaps we can make changes for the better. But this is a mistake. Markets just don’t work that way – direct cause and effect is difficult to pin down, and stocks don't always care about the chosen narrative of the day (even if we think they do ... it's complicated). Why is the market down be it today / this week / this month? Well, because investors are now in a poorer mood (pick your reasoning) and as a consequence demand for stocks is lower. That’s it. In all likelihood there are many reasons that move the collective herd. Stock market direction, particularly of the erratic variety, over narrow time periods are almost always simply a function of psychology. Psychology diverging from fundamentals (both up and down) that results in occasional market dislocation. This behavior can come on suddenly, and is very difficult to forecast. It can also resolve fairly quickly (average “pullbacks” last 6-8 weeks; “corrections” 13-14 weeks). So as I've habitually tried to impart in media interviews over the years, unless you can tell me the average mood of the average investor over the next *whatever* period, good luck. I cannot. But over the long-run fundamentals like economic growth, collective global prosperity, corporate profits, the level of interest rates and inflation will determine stock prices.

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As promised, I’ll pause here for a moment to provide my view of the current economic and market environment. To be crystal clear this is not a forecast. I don’t know when the next recession will hit. But it is a description of the fundamental macro backdrop as I see it that has me upbeat on the state of the economy and bull market despite recent anxiety.

?*the economy is doing fine – it’s not booming, but it is solid

*corporations are very healthy – at record profit levels with strong revenue and earnings growth rates, and lots of cash

*rates are still low – yes they’re rising but at a measured pace and along with a good economy; and real rates are barely positive / still negative in some case

*inflation is in check – helping real purchasing power, and are at levels that historically suggest decent stock returns going forward

*valuations are not expensive – not only in the context of the above, but also in the context of history especially after this most recent correction

*in addition, the highest quality leading indicators of where we may go from here all still look encouraging – these are:

*Conference Board LEIs (aptly named Leading Economic Indicators, perhaps the best indicator I know of, is still in an uptrend)

*Treasury yield curve (still positively sloped)

*money growth (M2, expanding at +3-5%)

*jobless claims (within LEI, still falling)

*real final demand (still growing at +2-3%)

*retail sales (at new cycle highs)

*ISM, new orders (within LEI), and select housing data like building permits (also within LEI) and new starts

*credit conditions (still benign)

*truck, freight, and rail tonnage data (expanding at +4-8% y/y, per most recent industry data; note: trucks, up +7%, do ~70% of total volume)?

All of these metrics are not without their flaws, but taken together they do have a good track record of leading recession by anywhere from 9-30 months as they peak and turn down. This is not a science, and the lead times are anything but precise. Nevertheless it’s the best we can do. And right now they all suggest things are fine.

I will say, however, that housing is currently one area where perhaps I am a bit more "on watch" as it seems to have slowed some recently. I suspect that this has more to do with a normal consolidation phase due to reduced affordability (high prices and rising rates) and the new tax bill (which has lowered housing incentives in some spots) after what’s been a strong multi-year upturn. My best guess is housing will be OK given the good economy, full employment, growth in new household formation rates, and present home inventory levels (low). But it will likely grow more slowly from here (not necessarily a bad thing).?

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OK, allow me to pick up where I left off a moment ago …

“But over the long-run fundamentals like economic growth, collective global prosperity, corporate profits, the level of interest rates and inflation will determine stock prices.”

It is on this key point where I wish to share a smart blog that I read a few weeks ago from one of my favorite investment writers / thinkers. It recently resurfaced on my radar given the bad October so far for stocks and the even worse opinions that always follow, including the highly unproductive fear-mongering. In a creative and witty manner Morgan perfectly addresses the silliness of this yearning, this scramble to find reasons today / right now to explain downside market volatility (funny, we don’t seem to have the same thirst for answers to the upside). At the center of his message highlights the fundamental problem of becoming overly reliant / attuned on the short-term noise in that it causes us to miss this more important “long-term news.” The big picture stuff that should render us optimistic about owning stocks for years and decades. There are always “reasons” to sell, the omnipresent “wall of worry.” But like anything in finance, and life for that matter, it is absolutely crucial to look at both sides of the ledger. Not just the liabilities, but the assets. Not just the cons, but the pros. Not just expenses, but revenues. And not just the negatives and what could go wrong, but the positives and what could go right.??

Warren Buffett famously penned in his Berkshire annual letter that “over the long-run, stock market news will be good.” Another statement to which I concur. See below to read the aforementioned blog, written in the form of a markets news story that we’re all far too familiar with as wealth managers. It nicely captures this long-term news, IMO.

Jason L. Ware, MBA / Chief Investment Officer

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LONG-TERM NEWS

Sept, 12th, 2018

NEW YORK – In what analysts called “the most important economic metric that exists,” 360,000 people were born yesterday, 78% of whom are expected to survive into late adulthood. Most will grow up to become productive, working members of their societies.

Subtracting the 150,000 global deaths reported during the day, economists said there were a net 210,000 new humans on the planet Tuesday. Amid news that three-quarters of the world now lives in a free or mostly free political state, at least 100,000 new humans entered the world on Tuesday who will be given the opportunity to learn the accumulated lessons and knowledge of the 100 billion people who came before them.

“This week alone, we’ll add the equivalent of the population of Seattle to the global economy in new people with the odds in their favor of growing up more knowledgeable and productive than you or me,” said Bryan Douglas, an economist with Deutsche Bank. “This year we’ll add the equivalent of the population of New York. Same next year. It’s just amazing.”

Asked what his forecast was for Q3 GDP, Mr. Douglas looked confused. “Did you just hear what I said about all the new people? That’s what’s going to matter over the coming decades.”

Google and Apple reported quarterly earnings on Tuesday. Analysts didn’t seem to care, noting that what happens in a 90-day window tells you nothing about long-term prospects.

The interest rate on 10-year Treasuries fell from 2.9% to 2.85%. Goldman Sachs, in a note to clients, said no one knew why this happened, and if you cared why it happened “you should reexamine your entire life.”

There were widespread reports Tuesday of people tinkering with crazy new ideas, particularly young people no one paid attention to, a few of whom will create the next great generation of businesses.

Across the world, people were said to be studying what worked and didn’t work in the past and using their observations to get a little better than before. “People get 1.5% better at what they do each year,” said Douglas. “It never seems like much, and it’s easier to pay attention to what’s going wrong in the short run. But a 1.5% increase in productivity each year compounded over a generation is incredible.”

In Baltimore, 24-year-old Tim Donovan opened a Roth IRA, depositing $500 into an investment account to compound over the next half -century in a vehicle that didn’t exist 20 years ago. “This is the first generation that’s had access to two things,” said financial planner Christy Eckert. “Super-low-cost investment options, and easy, tax-free investment vehicles. No other generation has begun their savings lives with those two advantages. Don’t underestimate where that will put them 40 or 50 years from now.”

Reports of Baby Boomers worried that younger generations lack the motivation and morals of their parents were met with pictures of a 1974 hippie commune and a plea from 28-year-old Travis Garner who said, “Look, every generation eventually figures it out and finds their own way. We’ll be fine.”

In California, 18-year-old Sarah Thompson began her freshman biology class at UC Davis where she’ll learn stuff we didn’t know when her parents went to college, while she won’t be taught stuff that’s since been proven false. “That’s how progress works,” her professor said. “A slow grind higher over the generations.”

The Dow Jones Industrial Average fell 48 points on Tuesday. Greg Jones, an analyst at Merrill Lynch, expected that no one would care about that useless, vapid, fact by tomorrow.

This blog and its contents represent?my?opinion and sarcasm only - it does not reflect the opinions of?Albion Financial Group. These musings should also not be confused for, or taken as, investment advice nor instruction / recommendation to buy or sell any security or investment discussed therein.