I hope everyone has been enjoying the holidays. Ideally, this has been a time for focusing on friends and family, not the recent market volatility. We know, however, that it may be difficult to completely ignore the financial headlines. With that in mind, I thought I would send out our thoughts on the past few weeks’ volatility and how we are positioned to weather it.
For those of you who read our most recent Quarterly Update letter, this missive will not sound all that much different. We did write in late October that we thought there was more downside to be had from this correction—however, the magnitude and speed was surprising. Nevertheless, we have been building cash in portfolios by taking some profits in stocks that had become fully valued, and by putting protective orders in on certain positions, which were then sold as the market drop continued.
And while, after several down days in a row, we had the biggest single up day in the history of the Dow Jones Industrial Average when measured in points, and the best in 10 years if measured in percent, that kind of massive rally is actually more indicative of bear markets than bull markets. Stocks don’t rally that violently in stable markets. So unfortunately, we may not be out of the woods yet.
The recent volatility has stemmed in large part from political instability. First, while the trade issues with China were in place long before December, the hope of a deal being reached at the November summit evaporated during the first week of this month—that was the first crack. The next was the Fed. Again, interest rates have been raised every three months for about a year and a half, but the hope was for a more dovish Fed (meaning less likely to raise rates) and that was not delivered. When President Trump voiced displeasure in the Fed, and specifically Chairman Powell, that created more uncertainty – if the President doesn’t trust the Fed, why should consumers or business owners? Then, to finish off the discomfort, we have the current government shutdown. As always, this is not a political statement on my part—one can agree, or not, with the Trump Administration on any or all of these issues, but the collective impact has created a lot of uncertainty, and the stock market hates uncertainty.
The obvious question is, where do we go from here? It is exceedingly difficult to correctly time the markets; even those who are right about the direction are often wrong about the magnitude and/or the timing. I do think more downside is possible, but not a massive, 2008-style drop. Both November and December were down months this year, a rare occurrence outside of a bear market. Additionally, the aforementioned massive rally of last week, while better than a massive market drop, is not an “all clear” signal; instead, it likely resulted from
extremely oversold, short covering. Finally, I have been discussing for the better part of a year how the cycle of volatility has changed from low to high—or really, to normal volatility; it just seems worse because we are not used to it. I expect this to continue for another few years. That said, saving the good news for last: if we do get a recession in the next 18-24 months, it is likely to be a shallow one, as the excesses that led to the last two big downturns are not present. Furthermore, the Fed could skip the March rate hike; we could get a trade agreement; or we could just continue to get positive economic data showing further growth—any of these would help boost stocks higher. The one great thing about downturns is that they provide the opportunity to buy at excellent prices. We have been picking up some great companies at good discounts to where they were trading just a few months ago. The Value Capture Portfolio (discussed in our 3rd quarter letter) has also thus far held up well under these conditions.
