Volatility

I felt compelled to share some thoughts on the recent market volatility.  What inspired me to write this letter, is an incredible statistic that I read last week.  The best performing mutual fund over the past decade according to Morningstar generated an incredible 18% annualized return.  This is a truly impressive accomplishment.  But what piqued my interest, is that the dollar-weighted return or what the average investor in this fund received over the past decade; it was -11% annualized.  That means for every dollar invested over that decade, the clients of the fund ended up with 30 cents.  You are probably thinking how is this possible?  The answer is volatility.  

It turns out that this mutual fund is highly concentrated with its holdings, and only owned 20 stocks.  Their approach is to only invest in their 20 best ideas.  This seems rather logical after all, why put money into your 100th best idea when you can add to your 20 best?  Well, this turns out to be a rather unconventional approach.  The average mutual fund owns 185 individual stocks which in turn dampens volatility.  By concentrating in 20 stocks, this fund had outsized volatility compared to the average fund.  When the fund was performing well, investors piled in and when the fund started to do poorly their clients did the one thing they could control - they sold.  In short, they consistently bought high and sold low, a certain recipe for failure.  Inactivity with investing is often an intelligent behavior, when making a change it is important to have a rational reason for the move.  Buying for the sake of diversification typically isn't good enough and selling because its down is even worse.  

Volatility Explained
If you ask a college professor to explain volatility, they will tell you it is a measure of risk.  The higher the volatility the riskier the investment.  But to anyone that has successfully traded in the marketplace, it is the patient investor's most valuable asset.  A college professor or financial advisor may try and dazzle you with bullshit by showing you fancy volatility measurements like the Sharpe and Treynor ratios, but it is really just a cover for their own insecurity.  Volatility is nothing more than a measure of the magnitude of the upward and downward movements of a stock price over a period of time (typically one year).  So why do I consider volatility an asset rather than risk?  The surprising truth is that the difference between the high and low price of the average stock in the S&P 500 and Russell 2000 over a year is 80%!  You are probably thinking that I have lost my mind living in the mountains.  But feel free to check my math, in a "normal" year about 98% of the 2,500 companies the high/low difference is between 40 and 60%.  In a crisis year (2000, 2001, 2008, 2009, 2020) the high/low difference is 200%.  Average it all together and you get approximately 80%.  

Volatility is a subject near and dear to my heart because I've built a career exploiting those who listened to their college professors for profit.  My day job is convertible bond arbitrage; it involves simultaneous purchase and sale of two securities to capture price differentials. Some might call that scalping, but I will opt for the French term arbitrage.  The error most people make is this; if a stock price fluctuates 40%+ its measure of volatility goes up as the price declines, and those who worship at the altar of academic finance sell because their risk measurements have risen.  If you have a strong sense of fair value paired with patience, we periodically get opportunities to invest during market's inevitable low tides.  This is how we turn other's measures of risk into our asset.  

The example of the return disparity I started the letter with is an extreme one, but it is still evident in the broader market.  Since the 1980s the burden of retirement has been shifted from the employer through pensions to the individual in the form of 401ks, 403bs and IRA plans.  The problem is individuals are inadequately equipped to navigate the markets.  A study by market research firm Dalbar found the average person loses 4% in returns per year through buying high and selling low.  That may not sound like much but over a 30-year career the average person has 70% less than they would have if they did not give into the temptation of selling during downturns.  We need to accept that volatility is part of the process and swim with the market tides. 

Volatility has another unique characteristic; it disappears over time.  If we extend the observation period beyond the conventional one-year horizon the measure of volatility declines rapidly.  Since our investment horizon is much longer than the time it takes for the Earth to orbit the sun, we therefore need to be aware the gyrations in the short run are nearly imperceptible over the long run.  In the price chart of Apple below the decline at the start of 2022 looks dramatic moving from $180 a share to $160 in a couple weeks.  On a 10-year chart, the move is barely noticeable.  

AAPL 1 year price chart (left) compared to 10 year (right)

Thoughts on the Market 
I want to provide a short lesson on economics.  From 1871 to 1997 the return on the stock market after removing the effects of inflation was 6.7% per year.  The corporate dividend yield and rate of earnings growth over that same period was also 6.7%, demonstrating overtime investment performance converges with business performance.  It is a simple concept, the value of the market can only reflect its output.  But that has not happened over the past few years.  Since the 2008 financial crisis, corporate profits have grown 5-6% per year on average.  Through the end of 2021, the S&P 500 grew at a 12% annual compound rate.  Why did this happen? Low-interest rates have driven a greedy behavior resulting in the strong market performance.  I see three ways the market can sustain this pace:

1. Rates can remain at historic lows 
2. Corporate profits claim a larger share of the economy 
3. The economy accelerates by a meaningful amount 

I think all three are unlikely. The Federal Reserve has sent a strong message that it will be raising rates aggressively in the near future to combat inflation.  Corporate profits at the end of 2021 were already at the highest share of the economy in history.  Finally, inflation has dampened consumer sentiment because it is eating up discretionary income that would typically be spent on items outside of staples like food, energy and housing. 

I have received numerous emails, phone calls and text messages from readers expressing concern over the recent volatility.  I am not surprised by the downturn, because over the past century the market has declined >10% once per year on average and >20% every 3-5 years.  Downturns are as common as the changing of seasons, however they cannot be timed.  If you are in my partnership, we are conservatively positioned and will be net buyers of stocks as the market declines.  Equities purchased at sensible prices coupled with low fees are still the best long-term investment in my opinion. 

I do want to express caution to my readers that own bonds, particularly long-dated, high-yield securities.  We are in a rising interest rate environment for the first time in 40 years and rising rates are like kryptonite to the bond market.  Interest rates and risk spreads (the interest rate that exceeds a US government bond of the same maturity) were near historic lows entering 2022.  As I have previously written, bond holders have not been adequately compensated for the risk they are taking.  I do have a close eye on shorter dated treasuries and investment grade bonds of up to two year maturities.  Navigating a rising rate environment will be a new challenge that require investors materially adapt to changes in order to survive and prosper.  If you have any questions, I am here to assist.


Cautious Investing, 

To The Front


This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice.  Past performance of any market result is no assurance of future performance.  The information contained herein has been obtained from sources deemed reliable but is not guaranteed.