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Preparing for a Pullback


The Importance of Wisdom

One of the core tenets of our new firm is that we will not be right all the time, but we do want to be wise all the time. Building wise portfolios means that we abide by a disciplined investment process even when it is tempting to get caught up in the emotion de jour. We rely heavily on empirical data as we manage portfolios, but we also supplement that data with more than four decades of combined market experience.

In our May 2015 newsletter, we mentioned that we would not be surprised to see a temporary pullback in the stock market over the next 6 to 18 months. When we explain what we mean by a pullback, we tell clients a 10-15% decline would be historically reasonable, and most clients respond by calmly nodding their head. When we tell them that a 15% drop in a $1 million portfolio means seeing a decline of $150,000, most clients gulp in disbelief. The purpose of this newsletter is to explain why we are anticipating a pullback and provide guidance on how we will prepare our portfolios for such a correction.

Is a Market Correction Always Bad?

Before we dive into why we would not be surprised to see a market correction in the next 6-18 months, let us first examine the fact that short term market corrections are both normal and healthy for disciplined long term investors.   In the chart below, the solid bars represent the annual rates of return of the S&P 500 for every calendar year (January 1 – December 31) dating back to 1980. You’ll notice that the market during that time experienced positive rates of return in 27 of the 35 years measured.

Take a moment to think about all of the national and international crises between 1980-2015. Think about the Cold War, Black Monday, the Savings & Loan crisis, the bursting of the dot com bubble, 9/11, the Iraq War and the Great Recession. Yet despite all of that, investors in the American stock market enjoyed positive rates of return 77.14% of the time (27 out of 35 years). Long term investors were rewarded for their discipline.

Now, please notice from the same chart (above) that in each of those years when the rate of return was positive from January 1 – December 31, there was also a red dot. Each red dot represents how much the market fell at some point during the year. The red number near the red dot quantifies the magnitude of that correction, from peak to trough. Now, this correction may have happened from April 7 – July 12 or September 25 – November 3, but each red dot represents a period of time in each of those years where the market fell temporarily. Therefore, we can conclude that short term corrections are normal for disciplined long term investors.

One often quoted but rarely heeded investment axioms is “buy low and sell high.” Currently, we believe that the market is a bit high, or overvalued, based on a number of metrics we follow. One example is in the chart below that follows the correlation between projected earnings and stock prices of the S&P 500, which is a benchmark comprised of the 500 largest companies in the U.S. Generally, the value of any company is driven largely by future earnings. We are noticing that the price investors are willing to pay for each dollar of earnings is trending higher and higher as shown by the green line (price) compared to the blue line (earnings). This willingness to “overpay” for earnings is leading us to believe that the market is slightly overvalued, relative to earnings.

While the relative value of the market requires interpretation, there is no doubt that the market is historically high. We have mentioned before that the U.S. stock market (as measured by the S&P 500) has more than tripled since its low of 676.53 on March 9, 2009, and it is hovering near all time highs. Is that alone a sufficient reason to expect a pullback? Not necessarily. But when you consider:

  • P/E ratios are 20% higher than their 5 year averages and 18% higher than their 10 year averages
  • Positive earnings surprises have generally been met with tepid response, while negative earnings surprises have been met with greater volatility
  • The current chapter of historically low interest rates and expansionary policy by the Federal Reserve, which has fueled some portion of this market rally, may soon be coming to a close.

These are just a few examples of data that lead us to believe it would be wise to prepare for a pullback.

Conclusion

Given our expectation of a market correction, are we recommending that clients cash out of their investments and hide their wealth under a mattress? No. Not at all. We are long term investors who manage money for long term investors. History has shown us, even earlier in this newsletter, that disciplined investors have been rewarded over time for maintaining an objective investment strategy.

Instead, we will consider the optimal allocation for each client that we have prescribed through our stress testing models. From this, we will recommend clients rebalance their portfolios to be slightly more cautious than the target allocation. If we are right and the market falls, we will have capital to deploy when stocks are cheaper. If we are wrong and the markets continue to rise, we will have plenty of exposure to benefit. Either way, we will err on the side of caution, which we believe is the wise path to take.

A Personal Update

We wanted to take an opportunity to thank you, our clients, for your encouragement and support over the last few months as we have made the transition to an independent registered investment advisory (RIA) firm. We realize that you have better things to do with your time than sign forms and gather statements, but we are very appreciative of your timely responses and affirmation of us as we have made this transition. Many of you have asked how the transition is progressing. We were told by our consultants that if 80% of the clients we invited actually came with us, then we should be fine. We are thrilled and grateful to report that between 96-97% of our clients chose to join us at our new firm. Thank you for having the confidence in us to guide you and help you reach your financial goals.

Finally, we have had many requests for an update on Eric and Allison’s adopted son, Noah. Noah just celebrated his 1st birthday and his 1st homecoming day in July. He recently started taking his first steps and loves to babble. Eric and Allison are extremely grateful for his sweet personality and content and joyful demeanor. We have included a recent picture here.