Intelligence

How Asset Managers Should Prepare for Market Volatility

Milton Ezrati

Chief Economist

Volatility seems to have terrified a number of investors.  Since it will likely continue for the foreseeable future, the question of the moment is: “How should asset managers, particularly equity managers, deal with it?”  Should they adjust their portfolios in some way to mitigate the effects? Should they flee equities, into gold as its rising price indicates some have done? Should they buy bonds?  Or should they go with the fundamentals of their investment process and all but ignore volatility? The last answer, cold-blooded and unexciting though it may be, is the correct one.  It, more than the others, goes to the nature of equity investing.

The volatility began during the closing quarter of 2018.  In turn, it created these five concerns:

  • The Federal Reserve (Fed), having raised interest rates gradually for years, left ambiguous what it would do in 2019. Investors, who had expected some abatement, began to worry that further increases would set back the economy and earnings and force a downward revaluation in equity prices.
  • Valuations had extended far enough to give concern. Markets by the last quarter of 2018 had reached new highs.  Price-earnings ratios and other, more elaborate valuation measures, if not yet flagging sell signals, had long since left behind the attractive valuations that in earlier years made a case for stocks almost regardless of anything else that was happening.
  • The threat of a trade war with China emerged as a real possibility, forcing additional unknowns into investor thinking.
  • Inflation had begun to pick up, albeit modestly, as had wages, forcing investors to consider pressures that they had conveniently ignored for more than a decade.
  • It became clear that the Democrats would command the House of Representatives. Whatever each investor’s political commitments, that fact introduced uncertainties into what might happen in 2019 and certainties that the policy patterns of the past two years, largely supportive of stocks, would change.

Some of this may get resolved in the coming months and quarters.  The Democrats will make their goals clearer and events will indicate how far they might get, including on the question of impeachment.  China clearly needs a trade deal, enough perhaps to disarm the matter of trade war. Valuations improved during the last quarter, markedly so in fact.  And the Fed, though it wisely has made no promises, has softened its language on rate hikes, giving markets more loving care than it did some weeks ago.  All this might offer hope, but that is the best it can do. The more reasonable expectation is that most of these influences, and perhaps others, such as an economic slowdown in Europe or more political trouble within the euro area, will continue to unsettle thinking and create volatility.

Faced, then, with the prospect of continuing volatility, asset managers need to keep two fundamentals of equity investing clearly in mind.

  • First, it is impossible to anticipate the kinds of day-to-day and week-to-week swings volatility imposes on investment life.  Those who believe they can guess such swings should seek the help of a qualified mental health professional. That kind of guessing is a fool’s game.  All a manager need do is make one false move and his or her performance can suffer irreparably. It is noteworthy in this regard that in the last 25 years one-third of the equity market’s entire gains occurred in less than 15 trading days.  Miss one of them and a manger’s performance could lag for years.
  • The second and more important for managers is to remember that volatility lies in the nature of equities.  That fact alone makes them a long-term investment, and only a long-term investment. Investors who cannot look beyond short-term swings have no business in equities.  Those who flee volatility to buy gold should never have invested in equities in the first place. Some days are down, some quarters are up; stocks rise over the long term.

It is these two considerations that led to the upfront conclusion here that asset managers would do best to ignore volatility.  Presumably, a manager, especially a professional manger, has an investment discipline. He or she should stick to it, whether it is value or growth based, whether it aims at small stocks or large, foreign or domestic.  If a stock looks good, buy. If it looks bad, sell. Volatility no doubt tempts managers to time such buys or sells. Since no one can know whether yesterday’s gains (or losses) will build on themselves or reverse tomorrow, trying to time that purchase or sale can lead as readily to pain as to joy.  If a manager feels a need to account for the violence of price swings, perhaps dollar cost averaging can satisfy. It gives the sense that one is doing something about volatility and will at least limit the damage of a wrong move. This concession to daily swings aside, the manager should stick to his or her presumably well-thought-out discipline.

Volatility is no fun unless one is a thrill seeker.  Since asset managers cannot anticipate the moves, they must continue to do what they do best: pick stocks on the basis of their discipline.  Volatility’s challenge is convincing oneself and one’s clients of the wisdom of that fundamental long-term approach.  It is the only sane way to proceed.

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