THIRD QUARTER ECONOMIC UPDATE
PREDICTING THE UNPREDICTABLE: MARKET CORRECTION OR COLLAPSE?
by Andrew Kleis
Prognostication is, it seems, an industry in our country today. Just turn on your TV or open the internet and you won’t have to go far to find an “analyst” or “commentator” claiming the world is ending. If we based our life decisions on the 24 hour news cycle, it might be hard to get out of bed in the morning!
The economy and stock markets are not immune from this sort of bluster. Watch an hour of CNBC or Fox Business sometime and you’ll be told a handful of times the economy and markets are teetering on the edge of oblivion. The same people have been saying the same thing for a long, long time. While they have no divine ability to predict the future, they have figured one thing out: If they keep saying the same thing long enough, eventually they’ll be right!
We don’t have the luxury of waiting half a decade or more to be right, or the hubris to believe we can predict something no one else can. Instead, we must base our decisions on the facts available to us, an understanding of history, and an understanding of risk. So what do those things tell us about the markets today?
First, we come back to one of the most fundamental beliefs of our firm:investors should be compensated for the risk they are taking. In our managed mutual fund portfolios, we have worked to maintain a posture that minimizes downside risk and volatility in favor of a consistent return. Our investment committee has remained diligent in this focus and the consistent results have proven this to be a valuable strategy for our clients.
Current market valuations would seem to tell us now is the right time for that type of portfolio strategy. While the economy continues to consistently improve, history would dictate we are in store for a market correction over the coming months. We are now more than 900 days since the last 10% market correction (which usually happens every 13 months) and typical volatility has yet to return to the market.
A normal market correction, however, doesn’t mean we’re going to have a market collapse. Investors’ fears of a 40% correction like 2008 – 2009 are certainly understandable given what we’ve been through. However, the strength of the economy today, strong corporate profits, and incredibly low interest rates would indicate the risk of a 20% or more correction is limited at this point. We believe our managed mutual fund strategies are well positioned to handle a 10% market correction. Recent market pullbacks (January 2014, August 2013, etc.) have proven the strategies have had limited downside capture relative to the market and continue to produce consistent returns.
Despite our focus on mitigating risk in the accounts, we also believe there are significant opportunities that are presenting themselves today. There continues to be tremendous opportunity in yield focused closed-end mutual funds. Our Enhanced Yield Portfolio has been built around this idea since last August. The primary impetus for this strategy was the historically large discounts to net asset value (NAV) we were seeing in closed-end funds. We would have thought the discount would narrow by now. It hasn’t, which still leaves us a tremendous buying opportunity for yield producing assets. We believe this is the type of “paid to wait” strategy which can perform well even if markets do endure some level of correction.
Domestic energy is also one of the best opportunities we’ve seen in the last several years. The supply and demand imbalance in natural gas, for example, creates what we believe can be long term opportunities in this space. We continue to search for additional ways to take advantage of this in our managed portfolios.
In summary, while there is no need for irrational fear in today’s market, it does pay to be mindful of the risks of correction and how your portfolio will respond in such a situation. We are confident today that our managed mutual fund portfolios do just that while also providing the opportunity for a consistent return. Drucker was right: we can’t predict the future. But we can position ourselves to take advantage of opportunities and minimize risk. That continues to be our focus every day as we know the results of these strategies are important to our clients’ peace of mind and their ability to build an enduring legacy.
