Following the presidential election on November 8, 2016, the S&P 500 rallied roughly 17%, reaching several all-time highs before hitting a few bumps in the road over the past couple of weeks. Not a bad run for equity oriented investors. Moreover, the period has been marked by extraordinarily low volatility as hope for the administration’s pro-growth agenda fueled investor sentiment along the way. However, as political mistakes have mounted, the likelihood of executing the administration’s regulatory, tax, and infrastructure platforms has been called into question. Fortunately, strong corporate earnings, a resilient domestic economy, signs of increased economic activity overseas, goldilocks $45-50 oil and still low absolute levels of interest rates have stepped in to support the market’s fundamental underpinnings.
Source: FactSet
Nevertheless, the North Korean standoff, the response to the events in Charlottesville and a new series of terror attacks have rattled investors and stirred up market pundits who essentially call for people to get into the losing game of trying to time markets. While the players on the market’s “wall of worry” frequently change, how to respond to them over the long-term generally should not. Quality, diversification and time are the allies of long-term investors, while the “money in motion” crowd generally is not. Nevertheless, pullbacks and corrections are normal, to be expected, and in some cases even healthy to combat complacency and to remind us that the market is not a super charged savings account. Volatility, like a hand to a hot stove, reminds us to handle risk with care, prudence and in suitable quantities for the task at hand.
Another concept we have been discussing internally recently and that could be helpful to investors is the idea of temporary (market) risk vs. permanent (business) risk. Basically, if a person invests in a diversified fashion, they are mainly exposed to temporary or “market” risk which is the risk that the market will drop in value temporarily from time to time. Temporary is loosely defined in terms of length but the concept is that, in a diversified portfolio you are not dealing with single company/sector product obsolescence, litigation risk, fraud etc. that could cause permanent impairment of capital. Rather with market risk, you are mainly dealing with economic cycles, investor sentiment and geo-political events, all of which ebb and flow but generally do not derail the tendency of markets to rise over time. If, however, an investor is not diversified and holds highly concentrated positions in individual securities (including private holdings) or sectors that could suffer from balance sheet troubles, outdated offerings, fraud or extreme valuation levels, then they are exposed to the potentially more permanent form of risk known as “business risk” (eg. Blockbuster, Enron, Worldcom, K-Mart, technology stocks from a valuation perspective in late 1999 etc.) which investors rightfully tend to fear the most.
In conclusion, if investors follow the three tenants of quality, diversification and time, market related volatility can be viewed more as a temporary rather than permanent form of risk. This mindset can help investors avoid panicking and perhaps even shift their mentality to thinking like an opportunistic buyer during periods of market weakness. Importantly, temporary risk can become permanent if a high quality, diversified portfolio is sold during corrections in an attempt to time the market. Of course, everybody’s time horizon and asset allocation needs are different, resulting in different tolerance bands for even temporary risk. However, asking yourself if you are truly exposed to permanent risk or just perhaps temporary market risk, could be a helpful concept for investors to consider when evaluating their portfolios during volatile periods.
John Micklitsch, CFA, CAIA, is the Chief Investment Officer at Ancora Advisors LLC a SEC Registered Investment Advisor.
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