Whenever the market has a pullback, the subject of the volatility of our Strategies comes to the fore. As of this writing, the S&P 500 has pulled back over 6% from the high reached on Sept 19th. This is the 16th decline over 4% of the S&P 500 since the bottom of the market in 2009, and every previous one has been a chance to monetize the volatility by putting more money to work. We believe this one is, as well. Our experience, though, is that most people do the opposite: they put money in after the market has gone up, and take it out after period of decline. Despite everyone knowing about buying low and selling high, that behavior is typically not part of the average investor’s toolkit.
We think this correction is of the same ilk as the previous 16, a natural feature of an ongoing bull market, and one that provides an opportunity to acquire shares at prices that are more attractive than those available a month ago.
The shadow of 2008, though, still appears to darken the views of investors every time the market corrects, as people reduce exposure in an attempt at “risk management.” A recent event hosted by the Santa Fe Institute shed some light on risk management in complex systems such as the stock market.
One of the speakers was Nassim Taleb, who came to prominence with two insightful and engaging books, Fooled by Randomness and The Black Swan. His most recent effort is Antifragile, which is about resilience in systems.
He noted that blow-ups tend to occur in systems that are rigid and do not move much, and that they are unexpected and difficult to predict despite people’s best efforts to do so. He spoke particularly harshly about risk management efforts and models such as VAR (value at risk) that assume normal statistical distributions as flawed and effectively useless. He compared risk managers to drunk drivers: the latter have “skin in the game” and can suffer death or jail time if they keep making the mistake of driving while impaired, whereas risk managers typically suffer no consequences when their flawed models lead to disaster. His advice was to learn to take risks you understand rather than trying to understand the risks you may be taking.
Warren Buffett’s always colorful partner Charlie Munger has described thinking that volatility is the same as risk, a common feature of risk models, as “twaddle and bullshit.” Buffett and Munger believe investment risk involves the permanent loss of capital, and describe typical volatility of capital markets as quotational risk.
Another speaker, John Doyle, a Cal-Tech professor of engineering and applied science, examined stability across a variety of systems. He said one commonality was that you maintain stability by imposing variability on the system. He used the human body as an example. Heart rate correlates with “everything” related to health (obesity, cancer, autoimmune problems, etc.). Exercise, or imposed variability, improves all conditions. The housing bubble became such a huge disaster because national home prices had continued up for so long that people assumed you couldn’t have national home price declines. More variability in home prices would have made the system safer by exposing homeowners, lenders and investors to the prospect that prices could decline as well as rise.
More broadly, Taleb and Doyle’s examples highlight the insight that the late economist Hyman Minsky called the financial instability hypothesis: namely, that stability causes instability by creating the illusion that risks are low, which leads people to take more risk. In this formulation, volatility and corrections are often safety valves, lowering risk instead of increasing it.
In our opinion, that is the case with this correction, as it has been with the 16 that have preceded it. We believe we are in an ongoing bull market that began in March of 2009 and has yet to run its course. Bull markets are built on three foundations: adequate liquidity, economic growth and attractive valuation. With the Fed holding short-term rates at zero, there is ample liquidity. The U.S. GDP and corporate earnings are both growing and at an all-time high. Valuations have moved up, but they are still reasonable compared with their own history and are exceptionally attractive when compared with bonds. “Safe” Treasury bonds trade at 50x a fixed coupon that cannot grow, while “risky” stocks trade at 15x with growing earnings.
As the saying goes, bull markets do not die of old age. Their demise is almost always a function of three things: an oil price spike, the Fed raising interest rates, or recession. Oil prices are currently dropping, the Fed says they will not raise rates for “a considerable time,” and a recession looks to be a long way off. Our friends at Omega Advisors track 14 indicators of a forthcoming recession, and the number flashing a warning is exactly zero.
We do not mean to sound complacent. One of the lessons of 2008 is to be vigilant about risk. We assess not only the risk of individual securities but the overall portfolio risk under a variety of scenarios. We have significant investments in our Strategies and certainly meet Taleb’s test of having “skin in the game.”
One of the tools we use to assess both risk and potential return for Opportunity Equity is a calculation of how far our portfolio holdings are trading from our assessment of their intrinsic business value. At the bottom in 2008 and early 2009, that figure was over 250%. Now it is a bit more than 50%, which is still at the high end of the long-term historic range of 30- 50%.
The goal of delivering long-term outperformance for our investors is what keeps us motivated and focused every day.
Investment Risks: All investments are subject to risk, including possible loss of principal.
The views expressed in this commentary reflect those of LMM LLC (LMM) portfolio manager(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading on behalf of any portfolio. Any data cited is from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. References to particular securities are intended only to explain the rationale for the portfolio manager's action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.
©2014 LMM LLC. LMM LLC is a subsidiary of Legg Mason, Inc.
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