Analysis of This Year’s Volatility

Volatility (especially the downside kind) has again seized the markets and investor attention. Why is it happening? Is it detrimental to investors? Where does CornerCap see risk and opportunity?

• The future is always uncertain, but everyone’s attention is on extra high alert. That’s a legacy of the financial crisis of 2008.
• Stocks are volatile by nature, but they are behaving as they normally do. “This time” is no different in terms of volatility and returns.
• CornerCap’s ongoing research sees meaningful imbalances in today’s market—e.g., above-average risk to over-priced “low beta” stocks (commonly considered to be defensive). We have actively re-positioned portfolios accordingly over the past year.
• Remember to work the plan you’ve set. And if you are clients of CornerCap, you have a plan. This goes for clients with long investment horizons, or clients with shorter ones.

The latest bout of volatility stems from the following recent developments:

• China’s economic engine is slowing at a time when the world needs growth. (See our recent comment.)
• Oil’s price keeps falling, when the world needs pricing stability. (See our original analysis.)
• The Fed plans to raise rates, but appears too optimistic in its growth outlook.

It started in the US with real estate, then passed to Europe. It’s starting to be addressed by China, a major growth driver of the world economy. Other emerging markets, such as Brazil and Russia, will inevitably follow. Low oil prices and a strong US dollar have exposed their condition.

We think that’s a low probability. Credit markets are healthier today. Currency reserves have also been built, and China has leeway in monetary policy.

At the same time, we should continue to expect liquidity challenges for some countries and industries in the coming years, particularly if economic growth remains elusive. Emerging market debt is higher than in 2008 by perhaps a third; low growth, sustained strength in the US dollar, and low interest rates certainly present a challenging environment.

The US, Europe and Japan have not yet achieved the full balance, by the way. There’s been notable progress (the US and Spain, for example), but sovereign debt of many countries in Europe has actually increased since 2008. Deflationary forces are still at play, and industries need competitive restructuring.

So, we certainly expect “aftershocks” as the global debt-to-growth balance moves to a more sustainable state.

Over the last 60 years, the market has dropped 10% to 40% (usually over three to 12 months) 34 times—essentially an average of once every two years. Recoveries typically take three to 14 months, although recovering from extreme drops (three occasions) can take several years. Clearly, significant drops have happened, and markets have recovered.

In just the past 20 years alone, we have had meaningful market shocks, including the Latin American debt crisis, the tech bubble, the Financial Crisis, and its aftermath. Yet over the past 20 years, despite some harrowing declines, the S&P 500 has generated 8.2% returns on average per year.

That is fairly close to long-term expected returns of 9%-10% since 1929. Stock returns aren’t predictable, but if history is a proper guide (and core economies show sustainable growth) they do tend to smooth to a consistent level.

Incidentally, the market weakness in 2016—while grabbing headlines because it is the worst start to a year in history—is not that abnormal for a 13 day return. In the last 60 years the S&P has declined by 9% in a 13 day trading period on average 2 times per year, or in 21 different years.

Taken in the context of long-term stock market returns, 2016 should be considered abnormal simply because these returns occurred at the start of the year.

Of course, it is usually easier for investors with long term horizons to ride out turmoil; volatility tends to be of greatest concern for retirees depending on portfolio stability or for institutions with a major liquidity requirement within the next five years. In most cases, a drop of 30% or more would be too challenging. It’s CornerCap’s job to help clients define the right mix of investments to weather unpredictable storms so they can achieve their goals.

Actionable research tends to be most meaningful at investment extremes (i.e., price differences are way outside of normal). We are constantly looking for those measurable extremes.

Present volatility aside, we have been seeing extremes in the markets for at least 12-18 months:

• US stocks aren’t expensive as a whole, but there are pockets that are expensive.
  • Stocks considered to be “low beta” or defensive (utilities, producers of staple goods, health care providers, dividend-payers) are trading near 12-year highs.
  • Cyclical stocks—those tied to economic cycles—are near 12-year lows.
  • We expect this performance gap to close, and have incorporated an above-average position in “higher beta”, more cyclical stocks.

• Stocks considered to be on sale—a.k.a., “value stocks”—are trading at a meaningful discount to stocks posting above average earnings growth (“growth stocks”).
  • Consider that “value stocks” were down -4% last year, where growth stocks posted 6% GAINS—a huge spread.
  • Over the past 20 years, value stocks (even with last year’s dismal performance) have posted 8.5% returns, ahead of growth stocks’ 7.6%.
  • We expect the current performance gap highlighted in the first bullet above to close and reward our value approach.

• International stocks and small stocks have offered better opportunity than US large stocks, in our view.
  • We have moved toward those investments (but not abandoning a US exposure) over the past 18 months.
  • We expect the relative performance gap to close, and have allocated to international segments where applicable for clients.

Stocks are volatile by nature, and emotions are currently high. People worry that more “down days” lie ahead for the markets—especially if rates rise, China’s economy stalls, oil prices fall, and companies miss earnings. It’s vital to have an independent, unemotional way to evaluate stocks and any investment.

In this environment, as in at any other time, CornerCap is not sitting on the sidelines. We are doing what we always do—actively researching what’s important and following customized investment plans for each portfolio we manage.