Stock market volatility has spiked in response to immediate market concerns about energy prices, weakening economic growth in China and changes to monetary policy, as well as momentous capital-market shifts during the past 20 years. In times like these, investors earn their stripes by staying focused on their long-term goals.

This year, financial markets are grappling with a long list of pressing questions. In January, China said that the nation’s economy grew 6.9% in 2015, its slowest pace in 25 years, and concerns abound about the prospects for its expansion because of debt-laden state enterprises and excessive spending on real estate and infrastructure. The collapse of oil prices—Brent crude prices have fallen from more than $100 in mid-2014 to a $30-$35 range today—has jolted the industrial sector. Everyone from oil drillers to private equity and debt fund managers to media pundits are spinning in all directions with predictions of recovery or recession. The vast divergence of views has prompted speculation about the pace of the Federal Reserve’s plan to increase interest rates.

Will China’s slowdown worsen? Will the U.S. expansion falter? Will the price of oil fall and perpetuate the slow-motion implosion in the energy industry? When will the Fed next raise interest rates? Will an “anomaly” flash crash hit equity markets today?

The honest answer is, we don’t know. We rarely, if ever, can predict the short-term twists and turns in the economy. We do know that reacting strongly to short-term fears about the unknown is most often a mistake. We believe that investors are most likely to reach their goals by focusing on the long term: relying on fundamental research, allocating capital to truly exceptional investments and staying true to a comprehensive plan.

Costly Conviction

Successful investing requires some degree of humility. According to “Freakonomics” partners Stephen Dubner and Steven Levitt, “I don’t know” are, together, the three hardest words for most people to say. In their 2014 book, Think Like A Freak, they talk about our reluctance as a species to say these words. Academic research suggests that the inhibition may be wired in at an early age. In a variety of studies, from 60% to 75% of kids between 5 and 8 years old give “yes” or “no” answers to yes/no questions even though they don’t know the correct response.

As investors, we strive to constantly remind ourselves about this human tendency. The fact is that more often than not, we cannot answer questions that would help us predict the movement of the market. Being humble is essential to our long-term investing mindset. Indeed, we know that many of an investor’s worst decisions result from convincing yourself that you know something when you don’t.

Given the breadth of the uncertainty currently weighing on the market, it isn’t surprising to see higher volatility. In January, the Standard & Poor’s 500 Index traded up or down by more than a percentage point during 13 out of 19 trading days, ending up with a 5.1% decline for the month. During periods like this—when the economy feels unpredictable, when you don’t know exactly what is coming next, when you are most tempted to deviate from longterm plans—it is especially important to stick with those plans and resist the temptation to overreact to short-term turbulence. As we think about rising market volatility, we should first acknowledge that the market’s choppiness during the past year is not out of whack with recent years. We are really looking at a tale of two eras: one exhibiting a baseline of volatility from 1970 until 2000, and the other showing meaningfully higher volatility from 2000 to the present.

Look Back Longer

So rather than ask why markets are especially volatile this year, it would be more illuminating to look at why markets have been more volatile during the past 20 years. We think about the changes we’ve seen in recent decades in three broad categories: informational, structural and regulatory.

Informational: When it comes to investment information, we all suffer from an acute case of “too much information.” CNBC shouts at us 24 hours a day, and the most miniscule events are immediately reported in stories all over the Internet seconds after they happen. The barrage disrupts an ability to weigh the import of any individual piece of information. Equally important, the advent of high-frequency trading (HFT) has completely collapsed the relevant time horizon for 99.9% of the investment transactions completed every day. HFT firms execute hundreds of thousands of trades each second for a single customer, just to jump on momentary price dips of a fraction of a penny. Last year, the scientific journal Nature published “Physics in Finance,” an article that reported on advanced laser and “hollow core” technologies that are accelerating the transmission of trade data by milliseconds. The new speed limit for investment decisions is the speed of light. Against that backdrop, we need to accept the idea that the “flash crashes” of recent years may simply be a new, permanent characteristic of market behavior.

Structural: High-frequency trading is evidence of a structural shift in capital markets as much as an informational shift. During most of the period since World War II, the stock market responded much more to the decisions of patient, long-termoriented decision-makers than it does today. The people who influenced capital flows and advised or influenced other investors were the likes of Warren Buffett, Philip Fisher and Peter Lynch—each with a differentiated approach but a common focus on the long term and on fundamental research. Their common strategy was simple: Buy good companies and hold them for a long time.

Today, most investors do not see themselves as patient owners of companies. Far more often, investors simply “buy the market” via index mutual funds or ETFs, meaning their every investment decision involves hundreds of stocks, not just one stock. Also, reduced barriers to trading have drastically increased the number of people making trades and the speed with which they trade. This includes self-directed retail investors as well as institutional, high-frequency traders. Moreover, sovereign wealth funds, managing the assets of countries such as Norway ($882 billion), United Arab Emirates ($773 billion) and Kuwait ($592 billion), roil markets with huge trades prompted by sudden shifts in other markets. Stock market volatility this year has been ascribed in part to selling by sovereign wealth funds seeking to make up fiscal shortfalls created by the collapse in oil export revenues.

Regulatory: Finally, regulation and central-bank activity has heavily influenced markets since the 2008-2009 financial crisis. For years, central banks around the world have supported their economies and capital markets by cutting interest rates to record lows and purchasing government bonds. As a result, markets are now hypersensitive to any hints of monetary policy changes and interest rate movement. What’s more, due to this already sustained offensive, central banks have less ammunition today to respond to further market downdrafts.

Another less widely discussed factor is the fear that liquidity in certain markets—specifically the corporate bond market—is drying up. Traditionally, banks have been the primary intermediary dealers of corporate bonds, but because of various postcrisis regulatory shifts such as the Volcker Rule and generally stricter capital requirements, bond dealing is far less attractive for banks. They have been reducing their market-making presence and dealer inventories for years. The risk is clear: If no one is there to buy when others are selling, the market’s movements will be more volatile. It is too soon to say how powerful this trend will be over time.

Fundamentals Still Rule

These informational, structural and regulatory changes intensify short-term volatility in prices during a typical day or month. In our view, the best response can only be to acknowledge increased short-term uncertainty, and to redouble our focus on long-term goals and market drivers. Even if we do see bigger and more frequent market swings in the coming years, the basic rules of patient and valueconscious investing have not changed. Companies that can grow their earnings consistently over a 10-year period should still be worth more at the end of those 10 years. Bonds with healthy credit profiles will probably still provide investors with consistent income and eventually return those investors’ principal at the end of their term. And investors who do an outstanding job of identifying great investments—in other words, situations when there is an attractive spread between the price of a stock or bond and the long-term value of the underlying business—should still have the potential to create wealth over time.

In the current investment climate, we are certainly not ignoring the risks and opportunities presented by the market’s volatility. During the past 12 months, we have shifted to a slightly more defensive position in client portfolios. We have reduced our weighting in equities overall, and in U.S. equities in particular, while adding to weightings in assets with lower risk profiles than equities, such as high-yield bonds as well as some private credit opportunities where appropriate for clients. We are actively monitoring situations where we feel the pendulum may have swung too far. High yield is a good example of a situation where recent uncertainty—in this case over the price of oil—has led to a major sell-off across the entire high-yield market, creating potential opportunities among bonds whose prospects actually have little to do with energy prices. We maintain allocations to emerging markets during a period when they have struggled mightily, but our managers have performed well on a relative basis and we still see excellent long-term potential for growth in these markets as their middle classes mature in coming years.

We always maintain a posture that balances upside potential, downside protection and appropriate liquidity in client portfolios, as dictated by each client’s circumstances. We focus on a “three-bucket” approach—which customizes each client’s mix of short-term cash balances, core portfolio and opportunistic investments—to ensure a consistent framework for long-term investing that works for clients practically and emotionally under all market conditions. Any tactical allocation decisions are made within the context of that overall long-term portfolio framework.

Why? Because we don’t know what is going to happen in the short term, so we always need to be prepared for a variety of short-term positive and negative outcomes. Over the long haul, however, if we stay true to our investment philosophy—maintain a long-term investment horizon, focus on fundamental research and, above all, invest in what we know and understand—we are confident that we can help our clients achieve the results they seek over time.

 

Other articles in this issue:

A Lift Amid Headwinds: The Appeal of Mortgage Bonds
With the Federal Reserve tightening for the first time since 2006, investors may generate competitive returns from the comparatively stable market for mortgage-backed securities.

By Tom Graff, CFA, Head of Fixed Income and John Henry Iucker, Fixed Income Research Analyst

‘The Ultimate Mobile Device’: Redefining the Automobile
For more than a century, automakers have provided a way to find adventure and new possibilities just beyond the horizon. Now the industry is also trying to satisfy consumers’ Web-focused wanderlust.

By Simon Paterson, CFA, Equity Research Analyst

Present at the Creation: Early-Stage Venture Capital
While headlines often focus on Uber, Airbnb and other private companies valued at more than $1 billion, we are looking beyond the so-called unicorns to find opportunities for bigger returns in early-stage venture capital.

By Jacob Hodes, Co-Head of Private Equity and Keith Stone, Private Equity Venture Analyst

 

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