October 2019 Market Update

by | Oct 5, 2019 | Market Updates

Stocks and bonds both grinded out gains in September despite the backdrop of a chaotic political environment. We recently broke down how returns are generated (you can find that update here to jog your memory). Here we’re going to focus on the other side of coin – risk.

We all want high returns with low risk, and from time to time, the market can slowly paint the illusion that risk assets deliver riskless return. The reality of risk can be swift and distracting.

We are continuing to focus on yield and risk management. Specifically, we are layering further exposure in portfolios that can increase in value when stocks decrease in value (hedging). It’s not that we expect big market declines – We are simply constructing portfolios based on the evidence.

Successful long-term investing requires a forward-looking orientation. When the immediate emotion of risk rears up and demands action, we want our orientation and action to be consistent and sound.

The backdrop looks that both stocks and bonds will deliver lower returns moving forward (not negative, just lower), and those returns will be associated with higher levels of risk.

Where we are different, is how we are preparing portfolios for what comes next. Our panel with ETF Trends covered this in great detail, if you weren’t able to tune in here’s where you can access it.

While we cannot avoid volatility (as we’d avoid return), we can prepare for a higher risk environment.

 

The Potential for Higher Risk and Lower Return – Bonds

 First let’s simply address what a bond is:

Company A issues a 10-year bond to raise $100, all from you. You give Company A $100 in return for a 10-year bond that pays you 3% interest once a year for 10 years. At the end of 10 years, you get your $100 back. Effectively, you’ve loaned them $100 for 10 years in return for $3/year.

What’s the risk to you?

  • Credit Risk: This is the risk that Company A goes out of business and can’t pay you the $3 they owe you next year or pay you the $100 For simplicity, let’s assume Company A is rock solid and your credit risk is low
  • Duration Risk (Interest Rate Risk): This is the risk that your $100 bond will lose value due to interest rates moving up. Think about it – you loaned them money for 10 years when the current market rate was 3%, so the price of your bond was spot on, $100. What if rates moved up to 6%? You’re now locked in for 10 years holding a bond that pays 3%! Obviously, rates moving up will lower the price of your bond if you wanted to sell it to somebody

What’s your potential return?

  • Yield: Clear form of return is the yield of the bond. In our simple example, 3%.
  • Price Appreciation: As with any investment, the price could Bond prices go up when interest rates go down. It’s the opposite of the duration risk scenario above. With rates at historic lows…we aren’t anticipating large gains from prices appreciating.

To summarize with one sentence and a picture: Yields are at historic lows while our duration is at historic highs.

 

The Potential for Higher Risk and Lower Return – Stocks

Valuations matter. Today’s valuations impact tomorrows return and the associated risk. Historically, overvalued markets are associated with lower potential returns and higher potential risks, a bad combination. Undervalued markets are associated with higher potential returns and lower potential risk, a great combination.

We use the Q ratio as a simple indicator for valuation (More detail here). Is it perfect? No. Is it effective? Yes.

The Q ratio is the total stock market’s value (numerator) over the fundamental value of the companies that comprise the stock market (denominator).

Think of this in terms of your computer. The numerator is the price you are willing to pay for your computer (market price). The denominator is the cost of the stuff used to make your computer (replacement cost). Theoretically, if you could go out and buy the stuff to build your computer for $500 and the market price of your computer is $1,000, you’d be inclined to just build a lot of computers and sell them on the market. The same thing holds true on the flip side. If for some reason replacement costs are higher than market price, you’d just buy the computer on the market. That’s a simple example of the Q ratio, but hopefully helpful in illustrating the ratio as it relates to the market as a whole and how the potential over or undervaluation can act as a magnet towards equilibrium.

Below is a chart of the Q ratio from 1900 through Q2 of 2019. You can see, outside of the spike in the late 90’s, we are at the highest levels of valuation on record. Common sense tells us that high Q readings would mean lower potential returns and higher potential risks while low Q readings would mean the reverse.

 

Impact on Our Portfolios

We’ve laid out the case above for why we continue to think we will experience lower returns with higher risk moving forward. Hopefully, it’s helpful to understand why we’ve been repetitive in our communication of tighter risk management and focus on consistent and repeatable yield. We’d like to close with two points of good news that need to be remembered if volatility picks up.

#1 – We’ve layered on more hedging and plan to add during Q4. A hedge is an investment designed to go up in price when the overall stock market goes down in price – think of it as a form of insurance. We won’t avoid initial shots of volatility, but we are prepared.

#2 – Your time horizon is longer than you think, and that’s a great thing! The probabilities of good outcomes are on our side. As mentioned above, don’t let the immediate emotions of risk distract you from the facts. The table below illustrates this better than words can.

As we usually do, we’ll have a quarterly overview of some macro items coming mid-month. If you’re into charts, let us know here and we’ll make sure you get it. As always, thank you for your trust and please don’t hesitate to reach out with questions.

 

The Aptus Team

251.517.7198

 

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