The Case for Risk Management in 2018January 2, 2018 12:52 pm
A friend recently said to me, “Anyone could make money in 2017.” Quite true, allowing for the slight exaggeration on “anyone.” The average equity investor benefitted from significant gains in the markets; The S&P rose 19%. IXUS (iShares Core MSCI International Stock Index) gained 28%, while even the traditional US Aggregate Bond Index had a decent year rising 3.54%. In addition, volatility was the most benign in recent history, with a maximum drawdown of only 3% all year, compared to an annual 14% drawdown over the last 35 years.
These levels of returns and comfort are unlikely to repeat themselves in the coming year. Yes, the global economy is on a roll — all 45 countries followed by the Organization for Economic Cooperation and Development are simultaneously expanding, an unusual confluence of events. And a good portion of the surprise upside to corporate earnings and revenue we experienced this past year could continue into 2018, especially with the new Tax Cuts and Jobs Act. Not to mention that higher interest rates and inflation have yet to be a real threat to returns. But the level of risk is picking up as we gradually move towards the end of the current business cycle.
Much of economic activity and investing moves in cycles or waves. What goes around comes around, albeit in a different format each time. Value stocks trump growth stocks, and then the reverse is true for a while. Commodity prices slump, struggling for many years until demand, inflation and currency factors reverse course and commodities revive again. And passive investing becomes all the rage, until correlations break down giving an opportunity for active investing again. In between, technology and innovation make room for change, so each time the cycle repeats itself it looks and operates a little differently. But at the end of the day we are talking about cycles, not permanent change, when it comes to most investing trends.
Of all the cycles we follow and care about, the business cycle is the one we keep an eye on most closely. Business cycles track economic booms and busts. Each cycle is different in terms of length, extent of growth, and severity of any recession, but the pattern is recognizable. The hardest part of monitoring business cycles is determining the tipping point that divides expansions from contractions.
It is this tipping point that is under debate right now. The current expansion is the second longest on record. It is also one of the slowest and weakest, supporting the theory that it has room to go before reaching any peak. And while there are certain traditional catalysts for when expansions end –inverted yield curves (i.e. substantive increases in interest rates), a burst of inflation, and changes in employment or spending, etc.– at the same time there are conflicting data, a range of opinion and inevitable uncertainty which can make it hard to know when the economy begins its descent. In fact, most people are unaware of when a recession actually starts, until it is declared retroactively by the National Bureau of Economic Research. As happens all too often, hindsight is the best predictor.
For 2018 our contention is that the bull market does have room to grow. We also believe that as the year progresses investors will become increasingly nervous that they will miss the signs of the expansion/contraction tipping point. Markets love to anticipate and to try to be the first to get major changes right. But the stock market itself is a terrible predictor of recessions (or recoveries for that matter). We could see a number of “false” pullbacks in stock prices before any true recession appears, which is simply another way of saying “the return of volatility”.
Let’s remember that volatility is also cyclical. It comes and it goes. It can be based on short term reactions or long term trends. It can be induced by algorithms and hedge funds or by simple investor fear. Momentum can compound volatility, while complacency can keep it at bay. And while it is a truism that what goes down eventually comes back up, each investor’s patience, self-discipline and ability to wait is different. Volatility challenges the buy and hold investor and demands that each investor understands his own tolerance for risk.
Whenever the next tipping point happens, it may not be enough for investors to passively ride the wave of the next recession. That is because it can be extremely hard to focus on the long run, when your goals and needs feel so important in the short run. In addition, buy and hold investing performs best in the early and middle stages of a recovery when it pays to be in the market. Investors who have just experienced a bear market are often reluctant to jump in.
However, during the late stages of the business cycle (which we believe we are currently in), more active risk management can be beneficial. It is on the downside that proper risk controls of portfolios can make a difference and be truly supportive of investors, helping them navigate what can become increasingly concerning waters.
So while we believe 2018 can be another profitable year for investors, we are also mindful that the recovery is aging and that we are getting closer to a time when the economy could dip into recession.
Yes, it has been a period when (almost) anyone could have made money in the stock market. But we foresee in the coming year or two that ‘losing less’ will become, once again, a dominant preoccupation of investors. And so the cycle goes on.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.