By Stephen Greco, CEO
The Rational View: How We Try to Stay Rational in an Irrational World
“If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.” — George Soros
So far, Q2 2018 has been rather dull, at least relative to Q1. After a year of almost no volatility, Q1 saw the S&P 500 move by at least 1% for the day roughly 30% of the trading days, or, in other words, one out of every three. Adding salt to the wound, the S&P 500 had its first correction since early 2016, losing a little more than 9% from its late January peak. Enter Q2: Volatility has not disappeared, but it has slowed for the moment. The number of days in which S&P 500 moved by at least 1% for the day decreased to 17% through late May. Also, the market has turned positive with the S&P 500 currently up about 3.0% YTD. Pairing the S&P 500 performance with an unemployment rate of 3.8%, consumer confidence at 98.9, and the year-on-year rate of the core consumer price index holding steady at 2.1%, leads us to acknowledge that we are still in a stable, yet mature economy.
This leads us to a question, “Has the stock market been more volatile than normal, or have we, as investors, overreacted?” We can answer this question by using a measurement commonly referred to as the “Fear Index” or the VIX. The VIX is a ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index. This index allows one to measure the implied volatility of the S&P 500 over the next 30-day period. The higher the VIX prices, the greater the perceived volatility. But what is normal?
- The Harmonic Mean of VIX from 11/01/2007-05/18/2018 had a baseline measurement of 17.24
- March 06, 2009, the day the S&P 500 touched a low of 666.79, the VIX had a high for the day of 51.95.
- Q1 2018 produced a mean VIX value of 15.4
- Q2 produced a mean VIX value of 16.4
The conclusion: the VIX has remained below historical norms so people may have overreacted.
Hold on to your horses, there is more to the story than just the measurement of VIX. How we feel depends on what we are used to. If you are used to 75-degree weather and you visit an area, where the temperature is 55 degrees, you will feel cold, even though 55 degrees is above freezing and, in some areas, (Michigan or Illinois) considered shorts weather. The same is true with investing. When we experience a market with very little volatility, we are taken aback when any amount of volatility enters the market. In 2017, the mean VIX value was 11.04. We saw a 39.5% increase in the value of VIX or the implied volatility of the S&P 500 in Q1 2018, which is enough to shock any retail investor.
Has 2018 been a volatile year in the stock market? No, at least according to the VIX, we have experienced less implied volatility than in the last ~9 years. However, were we spoiled by consistency of the 2017 stock market? Yes, and the feeling of increased volatility is real as the VIX jumped 39.5% from the 2017 mean to Q1 2018. So, what are we to do?
Successful investing requires that we take the rational view. As Ben Graham pointed out in The Intelligent Investor, the market is there to serve us… not to inform us. We desire to be risk-intelligent, controlling and managing rather than seeking or avoiding risk. One of the most obvious methods for doing this is by only investing in things we think we can value. We pay little attention to short-term price fluctuations, much preferring the perspective of value. That is, we ask the question, what is an asset worth and what is it currently selling for?
When you get towards the end of a market cycle, we find that novice investors are influenced more by recent events and the potential all-alluring excitement of immediate-term higher returns. Eventually the fear of missing out (FOMO) leads them to give in, throwing more and more resources towards the “highest earning investments.” Eventually the piper calls. On the other end of the spectrum, risk-intelligent investors seek extremely attractive, asymmetric risk-reward opportunities. They tend to notice valuations at obviously unsustainable levels. They increase their cash and short positions. During this phase of a market cycle there are no more non-pros to bid up prices and the pros have already taken a pause. Hence, prices seemingly have nowhere else to go but down.
Today’s animal spirits
At the moment we feel a bit bi-polar because there are a handful of reasons to be both optimistic and pessimistic.
On the bright side,
- interest rates are still at essentially historic lows,
- the Trump administration is dead-set on pro-growth policy, and
- unemployment is at multi-decade lows.
On the (potentially) gloomy side,
- debt has begun reaching pre-crisis highs, and
- valuations overall are still somewhat frothy on the expectation interest rates will stay low and economic expansion will continue.
Through it all, we are continuously on the hunt for quality, undervalued companies. They’ve been more difficult to discover given today’s pricing, but we remain confident in our ability to find opportunity. The hunt can get tedious, “boring” even, but again, that is good investing.
Stephen Greco, CEO