Avoid the Noise!

Given the market volatility we have been experiencing in 2018, it might be helpful to review prior periods of volatility to see if there is any information to be gleaned from them. The quick conclusion is that all of these events, with the exception of the Financial Crisis, created great buying opportunities after the initial downturn. Even the Financial Crisis created an excellent opportunity, if investors had the stomach for it.

A common thread during periods of volatility is the media’s continued use of sensationalism and fear mongering in an attempt to get ratings and attention. There is an old saying for news stories – “If it bleeds, it leads.” Shock value gets your audience to pay attention. The key is for investors to be aware of the “hype” and not react to it. One of the biggest mistakes long term investors make is to be distracted by short term events. If you are saving for retirement or any other event that is a number of years into the future, why should short term events matter? Our advice for all investors is to create an Investment Policy Statement and an asset allocation program that reflects your investment needs, and amend it when your personal situation changes – not in reaction to market volatility. Adherence to your asset allocation would result in reducing exposure to asset classes that outperform while adding to areas that have declined. In other words, it forces you to sell high and buy low. Be proactive, not reactive.

We know a gentleman who was a military and commercial airline pilot with a Master’s degree. In short, he’s highly educated and a very accomplished person. During the Financial Crisis, he panicked and converted all of his investable assets to cash in a reaction to market action and news headlines. He had a solid Investment Policy Statement and an asset allocation that met his long term needs. Like so many, he fell victim to the headlines which convinced him that his guidelines no longer applied, that this time was different, and that a change was necessary. Sadly, as of today, he is still sitting in cash wondering when to reinvest. He has been stuck for almost a decade. The really tough part of this story is that his “panic” had a significant effect on his retirement lifestyle. If he had stayed disciplined to his personal investment guidelines, his $1 million dollar equity portfolio at year-end 2008, would have been worth approximately $3 million dollars as of March 31, 2018.

In an effort to show why investment discipline is so important, we thought it might be helpful to look back at prior periods of market angst. We highlight what the media and market pundits were saying at the time, and what long term investors experienced. Take a look at the four charts below, each showing the headline issues that increased the volatility in the financial markets.

Europe

The first period revolves arounds the PIGS (Portugal, Italy, Greece and Spain) fiscal issues sending the global economy into recession.

China

In the beginning of 2016 there was a fear that a slowing Chinese economy would derail the global recovery.

Past performance is not a guarantee of future results. The S&P 500 returns are cumulative.

Brexit

Last summer there was concern that Brexit would push the U.K. into a steep recession and take the rest of Europe with it.

North Korea

More recently here in the U.S. the concern was that the U.S. and North Korea would escalate their tensions with some even fearing a nuclear war.

Past performance is not a guarantee of future results. The S&P 500 returns are cumulative.

While all of these events created short term volatility, none was indicative of where the markets were heading, nor did they have any implications for investors who stayed disciplined in their asset allocation process. Our belief is that the same will prove true with the current market fears surrounding potential trade wars.

How does one tell the difference between market volatility and a major downturn? Our experience is that most major market corrections are preceded by rampant speculation. Often speculative periods are due to faulty, self-serving beliefs created by Wall Street which spills over to investors.

The crash of 1987 occurred during the Leveraged Buy Out (LBO) craze where it was believed that junk bonds had similar default risk characteristics to investment grade bonds. Speculation increased around which company would be the next LBO candidate. Ultimately, when the debt came due, some companies could not pay it back. The simultaneous advent of portfolio insurance fueled the speculation by giving investors a false sense of security. This type of insurance was thought to protect portfolios from losses, and resulted in investors filling their portfolios with risky assets, which eventually led to a market collapse.

In the late 1990’s there was a belief that the “Dot Com” era was going to dramatically change global economies, and that technology companies would be the big winners. Consumers no longer needed bricks and mortar as we had clicks and eye balls. Speculation about a changing global economy brought on excessive valuation for stocks deemed to be associated with the new economy. At the end of 1999, the market was the most expensive on record with the S&P 500 trading at a price to earnings ratio of 31 times.

In the early 2000’s Wall Street had some convincing data that showed residential real estate prices in the United States never declined in unison. This played beautifully with well-meaning government initiatives which increased home ownership for the social good. Wall Street securitized mortgages, which removed the loans from the banks’ balance sheets. Both investors and the banks believed the balance sheets were much stronger than in past cycles, and therefore, a diversified portfolio of mortgages (CMO’s) had manageable downside risk. To add speculative fuel to the fire, the ratings agencies agreed with Wall Street’s faulty logic that somehow a diverse portfolio of sub-prime credit mortgages became investment grade AAA due to its diversification. As we know now, this hubris compelled many institutions to makes loans that they knew were speculative at best. This speculation helped create one of the worst economic downturns since the Great Depression, and without government intervention the aftermath would have likely been much worse.

If over-valuation and speculation are the keys to downturns, where are we now in that continuum? Overall, while the current market is not cheap, it’s not overly expensive either at 17 times earnings. While we are seeing widespread speculation in cryptocurrencies and in various technology companies, it is by no means pervasive. We remain constructive on the markets for reasons stated in our year end letter – corporate profits are strong and should increase due to continued global economic strength, tax reform, strong employment and increases in consumer confidence. Our advice for long term investors is to pay attention to valuation, fundamentals and the economy, while avoiding the hype we are all bombarded with every day. Let your asset allocation drive your decisions, not emotion.

I am delighted to announce a new member of the Granite Investment Advisors Family. On March 10, Victor and Sarah Soucy were honored with the arrival of Landon Soucy. Everyone is healthy and happy. Please join me in congratulating the Soucy’s, and welcoming Landon to the GIA family!

As always we thank you for the trust and confidence you place in us.

Best regards,

Scott B. Schermerhorn
Managing Partner and Chief Investment Officer

There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors’ recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.