“Wild Week Leaves Investors Reeling” is the front-page headline of today’s Wall Street Journal. After remarking on the week’s “sharp plunges and euphoric rises,” it goes on to rhetorically ask: “What is behind the remarkably sudden swings in the market?”
U.S. stock markets and many international developed markets grew strongly during a very long bull run in the aftermath of the global market crisis of 2007-2009. Over the last three years, an unusually low level of market volatility has been noted frequently by many commentators. During this last quarter of 2018, that low volatility has given way to the steepest decline since 2002, steeper even than that of 2008, which like 2002, continued to decline even further. The S&P 500 index had dropped 15% in December until this last week.
With the stabilization of the last three days, will markets continue to decline? We don’t know. And for policy management of multi-dimensional structured strategies, it should not matter.
The increased volatility of the stock markets has caused anxiety for many investors, new and old. The Dow Jones Averages had declined nearly 20% (to constitute a “bear” market) but many factor indexes show declines of more than 20% based on prices since the year 2018 began. Most of our clients with balanced equity/fixed income strategies, however, will experience much-reduced negative performance for 2018, likely ranging between minus 6% to minus 8%. While I am sorry for the unhappy news, that is well within normal parameters.
Media — like the Journal — and industry experts will endlessly speculate and prognosticate regarding which political or social event is driving market turbulence (most likely rising interest rates, aided and abetting the Federal Reserve in our opinion). But the driving force of huge swings is almost certainly the new technological reality that roughly 85% of all major market trading is on autopilot—controlled by machines, models, or passive investing formulas. These collectively have created an unprecedented massive herd of robot investors that trades incredibly fast in unison. Human beings simply don’t react that fast. But this is a new era.
Algorithms, or investment recipes, automatically buy and sell based on pre-set inputs or simplified forms of artificial intelligence. “Momentum” of market movements is a critical factor input. Today, quantitative hedge funds, or those that rely on mathematical computer models rather than on traditional research and human intuition, account for 28.7% of trading in the stock market, according to the Tabb Group — doubled since 2013.
Add to that an increasing number of passive funds such as ETFs, index investors, market makers, and those not buying because of fundamental views such as Dimensional Fund Advisors, and you get about 85% of all trading volume according to JP Morgan. Herein is crisis and along with it, a new opportunity for investing.
WHAT ACTION HAS PROFESSIONAL FINANCIAL TAKEN FOR CLIENTS?
On Friday the 21st and Monday the 24th we rebalanced most clients’ portfolios in a simplified but customized manner back to target policy allocations. We do not depend on an automated rebalancing algorithm. We call this our “Phase One” of our management process in a decline.
Since we largely employ Dimensional funds that trade as of day end, we waited for a special period of bad news and a day that most machines would not operate. Friday tends to be the day, since quants don’t want open positions over a weekend and I guessed that most had booked a fancy holiday get-away and either would be unlikely to change plans or be able to do so. It created optimal conditions for rebalancing. It was a gift that just kept on giving. The two days after Christmas were a record rise for the Dow Jones average and major U.S. indexes.
Blind faith in machines and models leaves investors vulnerable to biased and irrational outcomes. The solution? That which Dimensional Fund Advisors has used in its trading process since its inception — a healthy dose of skepticism and human oversight when trading securities. Remember this about computers and robo-advisors: it’s an algorithm, not an authority.
While peace of mind may not have been part of the holiday season due to continuing market declines and substantial swings, volatility is a normal part of all investing. Risk and expected return are related. The idyllic pattern of growth of the past several years that sucked in so many investors to make big bets by over-allocating into U.S. growth stocks could not last.
Additionally, we all know that reacting emotionally to turbulent markets and changing sensible investment strategies and management process is likely to be far more harmful to long-term outcomes and peace of mind than a periodic market drawdown. We remember that we have to be right twice: both when you sell, and then when you buy back.
We will discuss these matters more in our next Planning Perspectives. Should you have questions about our actions before our next planning meeting or have concerns about “Phase 2” should global markets continue their declines into 2019, please call or email us.
This is what we’ve expected for months. The problem is, when we get what we want, we may not want what we get — at least for a while. For those upset by the news, turn off the computer, and ignore the media. Enjoy family and friends as we welcome in what may yet be a very happy New Year.