Does the recent correction mark a return of a bear market or is it just another dip in an impressive rally? We analyze recent market behavior and offer some advice on how to invest in this unsettled environment.
Between March 2009 and April 2010, equity markets, as measured by the Dow Jones Industrial index, have enjoyed their most impressive rally since 1932. But this spectacular surge has also been interrupted by several steep market declines. So far these slides could be seen as pauses for breath rather than real corrections. Whether the latest correction conforms to this harmless pattern remains to be seen. We think it's high time to look behind the data and see what's driving this rollercoaster.
First, we would point out that the market's penchant for volatility lately results from two conflicting forces, one robustly positive and one darkly negative. On the plus side, after a deep recession, a vigorous economic recovery has been unfolding globally since mid-2009. On the dark side, markets remain extremely nervous and prone to panic. There is certainly no lack of things to worry about: European sovereign debt, potential monetary tightening in China or stricter US regulations on the financial services industry, as well as a generous supply of wars, threats of war, and natural and manmade disasters. The world indeed appears to be boiling.
Behind the struggle between good fundamentals and real or imaginary fears, we see one common thread: liquidity. Why are we so convinced that liquidity is all that counts? Let’s take another look at the rebound that began in March 2009. It was not restricted to the equity markets. All asset classes were carried along in the rising tide.
Anyone who bought gold in March 2009 will tell you, "It was simple. I saw that central banks were printing money. I realized we would be facing huge inflationary pressures, so I bought gold. Looking at how well gold has done since then, it was a smart move."
An investor in government bonds (with the notable exception of those who bought Greek debt) will be just as proud: "In March 2009 I felt we were facing a spiral of deflation and depression so I fled into US, German and Swiss government bonds. It was a good move; not only did I receive the coupon, I even made a capital gain on the principal."
An equity investor can say, "In March 2009 Warren Buffet started buying stocks again. I always do what he does, so I bought stocks and I have done nicely. Market indices are up 60-80%. The Sage of Omaha came back to stocks because he just felt things were bound to return to normal."
We have a tendency to ascribe our investment successes to our sharp intelligence, our good judgment and our flawless knack for timing market movements. Our failures, of course, are always due to external factors.
Our three successful investors each tells a story that makes sense in isolation, but the factors they cite are in fact mutually exclusive. Inflation, deflation and normalization simply do not all occur at the same time.
To reconcile the rises in assets as diverse as bonds, gold and equities, we need to take a step back. What else happened in this post-credit-crisis timeframe? The answer is simple: the billions of dollars, euros, pounds, francs and yuans printed by central banks to fight deflationary pressures after the financial crisis in 2008 have been invested across all asset classes, pushing all prices upward.
In the last 20 months, most investors have seen their portfolios exposed to two shocks. The first (negative) shock came from the financial crisis, which most people would rightly say was external; the second (until now positive) shock was the liquidity rally, which most people wrongly put down to their skills as investors. As a result of these two events, many portfolios feature major imbalances and bear no relation to investors' risk profiles or objectives.
Judicious investors should review their asset allocations and accept the truth the spectacular rebound between March 2009 and April 2010 was due to a flood of liquidity globally and not their perspicacity as investors. Now, we feel it is imperative that portfolios should be actively rebalanced, not only to reflect the risk profile and objectives of the individual investor, but also the risk/return characteristics of assets that might have changed during the last 20 months of erratic market performance.
Finally, it is important to remain flexible. The investment environment is still dominated by liquidity and this means it will remain volatile. The VIX index, a broadly cited measure of the implied volatility of the S&P 500, has again reached levels last seen prior to the Bear Stearns debacle in March 2008. In this context, we believe a buy-and-hold investment strategy could prove disastrous.
Until we are sure that the aftershocks of the financial crisis are truly over, it is essential to exercise caution. This demands rigorous discipline. Our rule of thumb: every investment should have a price target and a stop-loss, and both must be kept up to date. Above all, investors need to know when to sell, whether to take profits or to limit losses.
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