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Advisor's Perspective: Portfolio Strategy Q&A with the FC Investment Committee

When volatility prevails it is important to weigh your options and choose wisely.

Advisor's Perspective: Portfolio Strategy Q&A with the FC Investment Committee

It goes without saying that October was quite a challenging month for global markets. Selling pressure and volatility paved the way for widespread market declines. As investors ourselves and trusted advisors for our clients, we feel those emotions too. But as veterans of the markets, we also understand the necessity to anticipate and expect volatility but not overreact to it. We believe that times of volatility emphasize the importance of having a long-term investment plan. That plan should recognize potential volatility and have the mechanisms in place for addressing it. 

While many advisors will recommend to “do nothing”, we understand this is not as easy it sounds. Fear is a human element we cannot avoid, and goals, opinions and risk tolerances evolve over time. Depending on your unique situation, the concept of doing nothing can make you feel like a sitting duck. While stepping back and letting the markets correct themselves is often what we recommend, sometimes, we recognize that a different course of action is necessary to be prudent with our risk. We believe this is one of those times…


Overall, we believe the economy remains healthy, but we recognize the need to be prudent with our risk. Because of this, we have recently implemented some small changes to reduce risk across some of our portfolios. These changes are taken as risk-mitigation steps and are minor relative to our strategy. We view the recent changes as prudent steps in recognizing risks but not overreacting to them.

Additional changes might be prudent in the future if conditions deteriorate further but we do not see that at this juncture. The US economy is still experiencing strong growth, unemployment is very low and company earnings are strong. The strength of our economy should provide a foundation to support markets should they decline further, which is why it is important not to overreact to current conditions. If conditions improve, we would remove the changes. Either way, we will continue to monitor incoming data and remain objective. Emotions are our enemy in investing.

In times like these, we often receive numerous questions from our clients and readers. The following is a sampling of some recent questions. FCWS Investment Committee members Mike Fickell (MF) and Marc Zabicki (MZ) provide their insight to these topical questions.

"You pay a very high price for a cheery consensus. It won't be the economy that will do in investors; it will be the investors themselves. Uncertainty is actually the friend of the buyer of long-term values." -Warren Buffet

In times like these, we often receive numerous questions from our clients and readers. The following is a sampling of some recent questions. FCWS Investment Committee members Mike Fickell (MF) and Marc Zabicki (MZ) provide their insight to these topical questions.

It’s been reported that the market is overvalued and is likely going to have a significant correction or even a recession.  Is this the beginning of this period?

 

MF: I do not believe this is the beginning of a recession. We have already had a 10% pullback in the markets and most define this as a correction. Recessions typically create market corrections in the 25-50% range. I do not believe we are seeing signs of a recession yet. The US economy has grown nearly 3.9% annualized over the past two quarters, unemployment is near all-time lows and corporate earnings are strong. These are hardly the signs of a recession. You would need to see the economy begin to deteriorate first before a recession became more imminent and I do not believe we have seen that yet in any meaningful way.

What are the causes of this volatility?

MZ: We believe the current drawdown can be attributed to three primary causes. Two of which are somewhat related. First, the Federal Reserve, in late September, made a slight adjustment to how it communicates to the public in terms of forward guidance…i.e. the Fed will be providing less visibility into whether it feels policy is accommodative or restrictive. We believe when the market is confronted with less visibility, certainly, in relation to monetary policy, investors are likely to reduce the risk premium they are willing to pay for stocks. This, in turn, can have a depressing effect on prices. In our view, we have been seeing some of that issue manifest in markets. On a related note, Q3 company earnings reports and corporate forward guidance has not been as positive as it was in recent quarters. Some are attributing this modest change in tenor as concern the recent Fed tightening is starting to crimp corporate activity. This certainly is having its effect as well. Finally, we believe we are simply seeing some reversion to the mean in terms of market volatility. Equity market participants have enjoyed an unusually smooth ride over the last two years. Thus, in our view, a rise in volatility was inevitable and we are getting some of that volatility payback now.

MF: In my opinion, this volatility is most related to Mark’s last point, a reversion to the mean in terms of market volatility. Yes, there are concerns about higher rates and trade wars and their impacts on the economy. These are real concerns and real reasons why markets can reprice. But these were well known for quite some time. In my opinion, the sudden drop in the stock market was caused by investors beginning to reevaluate their perceptions about risk factors. Once the selling began, it prompted more and more investors to reevaluate their risk and heavy volatility ensued. We expect volatility to eventually settle into a more normalized range as the economy is still healthy. If economic conditions were weaker volatility could stay elevated for longer, but I do not see those economic conditions at this juncture.

Should I be concerned about the midterm elections? What are the possible market outcomes of the election? What should I do to prepare?

MZ: We believe potential changes to the construct of party power in Congress have been well telegraphed. The question comes down to the degree of those changes. We believe the market largely assumes a change in control in the House. However, a change of control in both the Senate and House would be outside the scope of most market expectations. The latter could have a definitive effect in terms of potentially reversing recent policy and/or putting a great degree of pressure on the executive branch. In our view, the market would not look upon a complete loss of Republican Congressional control favorably. Meanwhile, whether there are major political changes or not, we do not believe now or any near-future time would be free reign to take undue risk in portfolios. Now is the time to ensure risks are well-managed and exposures are well-balanced. This is not fire-drill call, but one that notes forward equity returns are likely to be a bit less than what we have gotten used to in recent years. That view is driven in by political considerations, fundamental considerations, and the application of prudent risk management.

What should I do about the trade wars? Is this the breaking point in our current bull market?

MZ: In our view, the trade war talk has been a bit overdone. Yes, current tariff plans may shave some off of 2018 and 2019 U.S. GDP (0.25% to 0.50%), and there may be a risk of more. However, we agree that a firm policy against those favored by the unequal application of trade law is necessary and could pay dividends for the U.S. economy in the future. Currently, there are plenty of instances where sectors of the U.S. economy are being benefited by the policy as well as those being negatively impacted. We look upon the policy as an attempt at inducing a change in trade behavior and governance, both at the World Trade Organization and at the country level…a change that is long overdue. Finally, we do not see current trade policies as a market tipping point. They are incremental to what is already going on within the U.S. economy and likely will not solely define the market's trajectory. The market's direction will be driven by the fundamentals of likely corporate and consumer outcomes, which still look good. However, the question being asked by most today is “how good” and “how much longer” can “good” last? We believe good can last a bit longer, although investors will want to make sure their portfolio is indeed prepared for more volatility.

What steps can be taken to minimize these effects?

MF: Investors can simply raise cash. Although cash has historically not provided great returns it can help from a psychological perspective. The most important thing in developing a long-term investment plan is having a plan you can stick with during difficult times. If your current investments are keeping you awake at night, then you should probably revisit the plan and raise some cash in the meantime. Some other measures you can take would be to buy some portfolio protection in the form of puts but this is often very expensive, especially now that volatility is very high. Allocating out of equities and into fixed-income investments that yield more than cash, such as corporate or high yield bonds is a way to reduce your risk but seek higher returns than cash offers. Reallocating away from more volatile equity sectors such as technology and other high growth areas into more defensive sectors such as utilities, telecom, and healthcare are other ways to remain in the equity market but reduce your risk.

Is there is still growth left in this current bull market? Is this past month just a pullback in an ongoing upward trend?

MF: I believe so. Trends often take a while to turn and the underlying economic fundamentals are still good. Markets can experience sharp sudden corrections against a trend but changing the direction of a trend usually takes a while. I think we will need to see the economy deteriorate further before a major bear market ensues.

If the market does continue to decline when do we change course to protect against losses?

MF: It will depend on the data we see. If we start to see a deterioration in leading economic indicators, this would be key. We favor taking some risk off the table to protect against making emotional decisions but prefer not to overreact until we see more meaningful data deteriorate. It is impossible to say where the sharp corrections will end but they tend to snap higher after the fear-driven emotional selling climaxes. Buying portfolio insurance in the form of put protections can be a way to protect a portfolio but that can be very expensive. I prefer, though, to make small changes and be more data dependent for bolder decisions.

Do other asset classes outside of equities offer better protection against high volatility?  What are the assets?  Under what circumstances are they deployed into portfolios?

MF: US treasury securities are typically the best performing asset during periods of high volatility but even those have not been great hedges in this environment because the Fed has been steadfast in raising rates. If volatility continues, I could see treasury bonds helping to offset equity losses but it’s not a 1 to 1 relationship. Treasury type securities can find their way into our portfolios and they have begun to do this is a slight manner. They will receive greater allocations if conditions

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About the Author

Craig Cavicchia

Craig Cavicchia

As a Co-Founder, Craig brings years of hands on experience helping clients make informed investment and financial planning decisions. Craig takes great care in understanding his clients near and long term goals and implements an investment strategy around those goals.

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