When the going gets tough

October was a tough month for investors. Global equities were down more than 7%. Global bonds were down more than 1%. Many alternatives, which should cushion the impact from falling equities, also struggled. Alternatives (proxied by the HFRI Composite index) fell almost 3% over the month. This month, we consider investment strategies and how we can help protect against downside risks.

What happened?

Major markets were weaker across the board in October. Global equities fell more than 7% – the worst month since early-2012. Table 1 shows market changes across a range of timeframes.

Table 1: Market movements

There has been no easy place to invest – not in October and not year to date. Traditional diversification hasn’t helped much from a headline perspective. Both equities and fixed income are down. Alternatives have also declined on average, albeit by less than bonds or equities.

Why did it happen?

Prescribing causes to market movements is difficult. Negative news flow can drive sentiment. And rapid changes in sentiment can impact trading flows and prices in the short term. In October, there was plenty of negative news flow. These included the US-China trade negotiations, the US-Saudi political issues, uncertainty around the US Mid-Term elections, concerns around a slowdown in global growth, and worries about peak earnings growth in the US.

Has anything changed in the outlook?

Short-term news flows do not drive medium-term outcomes. Fundamentals matter. So, the really important question after a market correction is, has the fundamental outlook materially changed? The answer to this question is not really. We continue to expect the US to grow well over the next 18 months. After that, a recession beckons. Higher Fed Funds rates will prove a challenging environment for leveraged balance sheets. While we think the most likely outlook has not changed, the range of uncertainty around that outlook has increased. And that means that we are going to see more volatility in the markets in the months and years ahead. That will feel uncomfortable. Figure 1 shows we have gotten used to unusually low volatility over recent years.

Figure 1: Volatility (measured by the VIX Index) has been unusually low.

Near-term moves are uncomfortable

It is uncomfortable for owners of equity to experience falling prices. Yet it happens often. Figure 2 shows the peak to trough drawdowns over the past 40 years.

Figure 2: Peak to trough drawdowns in the S&P500

We have written before about the importance of having a clear sense of valuation and what the market is discounting relative to our own view. Doing so allows us to look through near term movements – even significant ones like we experienced in October – and instead focus on the longer-term. This means we are not tempted to sell positions when prices fall. This is human nature, but a disciplined, repeatable investment process should avoid such short-termism and likely losses. Instead, falling prices should be an opportunity to add positions if there is a clear view around medium-term valuations. But we know that short-term moves happen, and they are painful. We don’t profess to be able to predict these short-term movements. Instead we aim to build portfolios that will be impacted less by volatility over the medium term.

How do we build portfolios to reduce volatility?

We have allocated a significant portion (i.e. greater than 10%) of our portfolios to alternatives. Those alternatives have generally performed well and helped us to achieve mostly positive portfolio returns year-to-date, exceeding our benchmarks– despite the volatility through the rest of the market. We continue to believe that a well-diversified portfolio with a sensible allocation to alternatives will outperform over the medium to longer term. And such a portfolio will help dampen the impact of broader market volatility in the nearer-term. For more information on our portfolios and how we can help achieve your goals, contact Oreana Financial Services here.

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