How Advisors and Investors Can Avoid The Next Recipe For Disaster

Twice per year, Greg Stewart takes a look from the shoreline to give us an idea of what to expect in the months ahead. We call it his Surf Advisory.

As the Trades Turn: So Far in 2017

2017 has brought us a great deal of rotational trading. Initially, sectors like energy, materials, and industrials - value oriented arenas - were heavily supported by the implication that we were going to start rebuilding America in a very tangible way. Bridges, highways, and all kinds of infrastructure were going to be created and renovated. Stretching back to post-election 2016,  those companies that benefit when building becomes a focus rallied aggressively, while some of the more growth-oriented sectors, like technology, underperformed.

The infrastructure rally didn’t last very long, as trades rotated out of value sectors and into growth sectors. A lot of the trades that had worked after the election unwound pretty rapidly; we saw some areas such as energy and financials sell off, and small caps didn’t participate at all. Growth sectors ended up doing very well, yet some of those areas that you would expect to follow, and correlate with growth, acted quite out of character, and didn’t follow the trend.

Some of the major averages were up decently around the end of June and beginning of July, including the DOW and NASDAQ. Gold did well, and even Europe was doing okay. Commodities, energy, and the U.S. dollar however, didn’t join in the fun.

The Next Six Months: Guessing Gets You Nowhere

The use of quantitative models, based on solid data and analytics, can provide the insight we need to make quick decisions, when appropriate. Instinct, while incredibly reliable in certain types of crises, is not particularly useful here.

Despite our distaste for forecasting, here are a few thoughts:

The markets have been gyrating somewhat sideways for the past few months. In early March, the S&P 500 was sitting at around 2390. At the beginning of July, it was at 2400. It was essentially four months of sell, recover, new high, sell off again. The rotation between sectors, each taking turns at leading the pack and falling behind, continued and may very well continue for some time. It’s probable that there will be another round of selling off, followed by prices pushing higher, with the result being limited upside - unless you are tactically active about your investment management.

Risks and traps abound this year, from the potential for military conflict in a new arena, to possibly raising the debt ceiling, to federal policy that has yet to be clarified. These are all external factors that we cannot control.

What can you control? Your own behavior

As we mentioned recently, over the past few years there has been high correlation between asset classes, which has significantly reduced our ability to benefit from diversification.

Even when stocks are outperforming bonds, or vice versa, but they’re still on the same path and moving in the same direction, it’s easy for us to look at these, spot that year-to-date returns are fairly similar, and question the validity of diversification.

Why have investments in different areas?

Why not just buy the index and call it a day?

When we look at results over short time frames - quarterly, annually, as opposed to decades - and don’t really dig deep into how we got the return that we received, these are obvious and easy questions to ask. When you purchase an investment and see that it’s not even matching the market, why would you want to keep it?

The reality is that this investment, which is trailing right now, might just be the investment that turns around and reduces your losses (maybe even provides gains) when other investments that are gaining right now, start to run the other direction.

We all know this intellectually, but we don’t often behave accordingly.

If we know that our diversified portfolios will perform over the long haul, why do we make choices that are against our better interests?

The truth is not that we are blinded by fear, or that we lack smarts. The truth is that we’re actually quite intelligent, and our brain is actively analyzing the data. The problem is that our brain takes a look at this piece of data - perhaps the one that indicates a return that isn’t going in the direction we want - and extrapolates it out, far into the future. Our brain understands that if this return continues, we’re up a creek.

As investors, we need to learn how to control our reaction to volatility, to stay invested, and navigate potential downward turns while still feeling good. Traditionally, asset classes don’t move in the same direction at the same time. We should therefore choose to invest in multiple asset classes so that when this is going down, that is going up, which reduces the total volatility in our portfolio.

Yet, when we see this moving down, we say, “Forget this thing. I want more of that.” Which, from a short-term perspective, could be the most logical move. In the long-term, however, we all know it is not.

Everybody wants upside, without any downside. As investors, we all need to step back and examine whether emotional reaction is the correct place from which to make decisions.

Shortly after 2008, we met with an individual who was interviewing managers. We reviewed his portfolio and found that he was down almost 70% - when the market, at its worst, had been down 50%. How did this happen? It’s surprisingly easy.

Investment A was working, so he bought that. It stopped working, so he sold it and bought Investment B, which had been working. Then it stopped working… and the cycle continued, swirling its way down to the bottom. Jumping from investment to investment, trying to stay with the next big thing, is a surefire recipe for disaster, and it’s emotion that has written the cookbook.

To be successful as investors, we need to actively work against our natural responses, and act in a way that may initially appear, and feel illogical. This should be given careful consideration.

- Greg Stewart, CIO