Monthly Market Commentary

February 2016

It was certainly a January to to remember - for all the wrong reasons. Stocks got off to one of their worst starts ever as U.S., developed international, and emerging-markets stocks all dropped more than 10% intra-month before rebounding to finish January down 5%, 5.5%, & 5.7%, respectively.

The late-month turnaround was, in part, due to announcements of expanded monetary stimulus from global central banks. First, the European Central Bank announced that risks are rising and further monetary easing may be needed. Not to be outdone, the Bank of Japan then announced they would cut their deposit rate to negative 0.1%, in an effort to boost the Japanese economy and equity markets. And, investors increasingly questioned whether the U.S. Federal Reserve would follow through on its plan to further raise rates.

Core bonds were the main beneficiary of the volatile environment, generating a solid 1.4% return as investors rotated out of risk assets. As a result, bond prices rallied, driving yields on the 10-year Treasury below 2%. And, our new position in long-term treasuries (VUSUX) is up 8.67% so far this year.

Crude Oil and Financial Markets

As if the challenging environment for stocks weren't enough, investors also had to contend with oil prices falling dramatically. While lower energy prices may eventually benefit consumers and the economy, at present they're contributing to uncertainty in the financial markets as investors try to determine whether and to what extent problems in the energy space could spill over to the broader economy. Two things to keep in mind about oil: (1) at $30, the inflation adjusted price per barrel has not been this low since the Shaw left Iran in 1979 and (2) this is equivalent to the greatest tax cut for the middle class in modern history. So, at least for those not working in the oil industry, enjoy this while it lasts - because it probably won't.

For a timely white paper on the correlation between oil and the financial markets click here.

2008 Again? Not Hardly

Along with this rocky start to 2016, the usual suspects began to find their usual megaphone in financial journalism, as they peddle their latest catastrophe scenario: that this is going to be a replay of 2008.

This could be an interesting theory, to which one might cling if (but only if) one were in possession of absolutely none of the facts.

2008 was first and foremost a credit crisis, brought on by the sudden realization that the greatest global credit bubble of all time had been supported by collateral which, however highly rated, was in fact worthless.

As the WSJ's Justin Lahart wrote in the weekend edition of January 16-17, "Consider households, which were at the epicenter of the mortgage crisis. At the end of 2007, household debt levels equaled 130% of income, according to Federal Reserve figures. Today, that has dropped to 103% of last year's third quarter. "Further, thanks in large part to super low interest rates, households are now devoting 15.3% of income to meeting debt and other financial obligations versus 18.1% in 2007.

"Similarly, U.S. banks today are in a far better position to absorb losses than during the financial crisis. The 31 financial institutions in the latest annual 'stress test' administered by the Fed had $1.1 trillion in common equity capital at the end of 2014 compared with $459 billion at the start of 2009. "Banks' common equity capital ratio, which measures the buffer banks have relative to risk-weighted assets, was 12.5% at the end of 2014. This is more than double the 5.5% ratio in 2009's first quarter." (Emphasis added.)

The banks have undergone a historic deleveraging, with virtually all the Fed's quantitative easing ending up as their excess reserves. Households have also deleveraged spectacularly, even as the value of their homes has risen. Household debt to household income is now at a fifteen-year low. Lots of other things can still go wrong, but a repeat of 2008 is very unlikely. Mr. Lahart thoughtfully concludes, "After 2008, many investors have come to fear that every episode in financial markets is another black swan. They should remember there are white ones, too."

A Visual History of Market Crash Predictions

With legions of catastrophist opportunists coming out of the woodwork and predicting market declines of seventy and eighty percent, the best resource for the broadest circulation you'll find is Michael Johnston's posting A Visual History of Market Crash Predictions It is a beautifully illustrated, laugh-a-minute-romp through the last several years of the direst forecasts by the most egregious perma-bears.

Align's Strategy

When an asset class performs better than expected while another performs worse than expected, we rebalance - trimming the out-performing asset class and adding to the under-performing asset class. Lately, we have trimmed short-term fixed income and added to small caps, emerging markets and international stocks (which have each under-performed). The idea is to sell high and buy low.

Our strategic allocations, which form the foundation of our portfolios, have a time horizon of 10-plus years. In the equity section of those allocations, we currently have dedicated 49% to U.S. equities, 11% to emerging markets, and 40% to developed international markets, including Europe and Japan. These allocations represent the relative market capitalization of each of these broad asset classes and provide our clients with access to the vast investment opportunities offered globally. Importantly, global diversification provides valuable diversification benefits to investment portfolios.

Sticking with long-term strategic allocations makes sense and, we believe, increases the odds of success. We also believe we can take advantage of valuation discrepancies among asset classes by executing our disciplined re-balancing activities in a timely and accurate manner. Over short periods, markets are driven by cycles of fear and greed and investor herd behavior. When that happens, we sell assets that the herd is buying and buy assets that the herd is selling. By design, our strategy is almost always counter-cultural and contrarian.

Stick with the herd and you won't be blamed too much if you fail, as long as you have lots of company. Ultimately, we think that type of approach reflects a lack of discipline and creates great potential for being whipsawed - chasing what's been working or buying high and selling low - and ultimately leading to mediocre long-term returns. But, it's challenging to maintain your long-term discipline when some asset classes seem to be performing so much better than others you own.

If we knew, for certain, which asset class would shoot the lights out next, then, of course, we'd put all our eggs in that basket now and then become defensive and sell that asset before it declines. We don't believe that type of market timing is possible on a consistent basis. We can't do it and we are not aware of anyone else who can either. If anyone tells you they can do this for you, run (don't walk).

However, we do have conviction that our investment process will add value over a long-term investment horizon. Investing is a long-term process, or at least it should be in our view, typically spanning decades for most of us. Those who are seeking certainty with regard to short-term investment results are likely fooling themselves.

It's easy to build a portfolio that buys what seems to be "going up" and sells "what's going down". That is what most investors do - especially those who pay too much attention to the pundits on the TV and the internet. And its a key reason why most folks experience mediocre investment results.

That's not our approach. We are more focused on absolute returns and downside risk management, rather than chasing what's popular now. We firmly believe that over the long term, our disciplined, academically grounded, investment approach will deliver solid investment results for our clients - just as it has done over our firm's long history.

Living With Volatility, Again

Volatility is back. Just as many people were starting to think markets only ever move in one direction, the pendulum has swung the other way. Anxiety is a completely natural response to these events. Acting on those emotions, though, can end up doing us more harm than good.

There are a number of tidy-sounding theories about why markets have become more volatile. Among the issues frequently splashed across newspaper front pages: oil, China, and the Fed. In many cases, these issues are not new. And, only new "real news" moves markets. For example, the US Federal Reserve gave notice years ago that it was contemplating an increase in rates. This is not news.

The increase in market volatility is an expression of uncertainty. Markets do not move in one direction. If they did, there would be no return from investing in stocks and bonds. And if volatility remained low forever, there would probably be more reason to worry.

As to what happens next, no one knows for sure. That is the nature of risk. In the meantime, investors can help manage their risk by diversifying broadly across and within asset classes. We have seen the benefit of that in recent weeks as long-term treasuries have rallied strongly.

For those still anxious, here are seven simple truths to help you live with volatility:

Don't make presumptions.
Remember that markets are unpredictable and do not always react the way the experts predict. When central banks relaxed monetary policy during the crisis of 2008-09, many analysts warned of an inflation breakout. If anything, the reverse has been true.
Someone is buying.
Quitting the equity market when prices are falling is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the wise long-term investors.
Market timing is hard.
Recoveries can come just as quickly and as violently as the prior correction. For instance, in March 2009 - when market sentiment was at its worst - the S&P 500 turned and put in seven consecutive months of gains totaling almost 80%. This is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
Never forget the power of diversification.
While equity markets have turned rocky again, highly rated government bonds have flourished. This helps limit the damage to balanced fund investors. So diversification spreads risk and can lessen the bumps in the road.
Markets and economies are different things.
The world economy is forever changing, and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector but good for consumers. New economic forces are emerging as global measures of poverty, education, and health improve. It is very important to distinguish between the economy and the markets. To be clear, the economy does not and never has predicted the short-term direction of the markets.
Nothing lasts forever.
Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.
Discipline is rewarded - sooner or later.
Market volatility can be worrisome. The feelings generated are completely understandable and familiar to those who have seen this before. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.

Quote of the Month

"Do you know what investing for the long run but listening to market news every day is like? It's like a man walking up a big hill with a yo-yo and keeping his eyes fixed on the yo-yo instead of the hill."

Alen Abelson

10 Bear Market Truths by Ben Carlson, CFA. Used by permission.

A few truths about bear markets in stocks:

1. They happen. Sometimes stocks go down. That's why they're called risk assets. Half of all years since 1950 have seen a double-digit correction in stocks.

2. They're a natural outcome of a complex system run by emotions and divergent opinions. Humans tend to take things too far, so losses are inevitable.

3. Everyone says [bear markets]* are healthy until they actually happen. Then, they're scary and investors who were looking for a better entry point begin to panic.

4. The majority of the people who have been scaring investors by predicting a bear market every single month for the past seven years will be the last ones to put their money to work when one actually hits.

5. It's an arbitrary number. I have no idea why everyone decided that a 20% loss constitutes a bear market. The media will pay a lot of attention to this definition while it doesn't matter at all to investors. The 1990s saw zero 20% corrections but two 19% drawdowns. Stocks also lost 19% in 2011. Does that extra 1% really matter?

6. Buy and hold feels great during a long bull market. It only works as a strategy if you continue to buy and hold when stocks fall. Both are much easier to do when stocks rise.

7. Your favorite pundit isn't going to be able to help you make it through the next [bear market]*. Perspective and context can help, but there's nothing that can prepare an investor for the gut-punch you feel when seeing a chunk of your portfolio fall in value.

8. History is a broad outline of what can happen in the markets, not what will happen. Every cycle is different.

9. [Bear markets]* are very difficult to predict. All of the valuations, fundamentals, technicals and sentiment data in the world won't help you predict when or why investors decide it's time to panic.

10. These are the times that successful investors separate themselves from the pack. Most investors mistakenly assume that you make all of your money during bull markets. The reason so many investors fail is because they make poor decisions when markets fall.

*Emphasis added.

Thanks for taking a look. Please contact us with any questions whatsoever. We're here to help.

Sincerely,