The recent stock sell-off certainly has our attention. Yesterday, October 14th, the S&P 500 closed about 6.6% off its high, set only a month ago. And writing before the opening of October 15th, it looks like another bad day. As always, there is a chance of a further stock market decline, but we think the risk reward proposition of the stock market is still favorable. Accordingly. we have not reduced our exposure to stocks yet, though we are monitoring the situation closely. Why might investors want to cut their positions and why hasn’t Astor?
The fundamental argument for panicking
The strongest fundamental argument for reducing equity exposure is the possibility of a renewed recession in Europe, perhaps leading to deflationary fears in the developed markets. Recent news in Germany in particular has been disappointing, and any growth in the periphery is coming off of a very low base. We started noting weakness in the Eurozone in July, with our latest update last month here. In the last few months, the ECB has raised and disappointed expectations for a dramatic non-traditional easing. A renewed recession Europe would reduce growth prospects in the US somewhat and may have an outsized impact on large cap stocks which generate a good deal of their profits outside the US.
The “fear itself” argument for panicking
Roosevelt said, “The only thing we have to fear is fear itself.” Similarly, the sell-off in stocks itself (and the rise in the VIX, part of the same phenomena) is its own reason to cut positions. While we do understand the inclination, and we think a sober, quantitative risk control framework is important, we are not so sure that just cutting stocks because they are going down in price is always the best method. In fact, if you stayed out of the stock market every month which started with a 5% of greater drawdown you would cut your compounded annual growth rate by half over the period of 1970 – 2014. You would have to be a fearful investor indeed to be able to sacrifice half your returns.
Note that not all of the decline in the price of risky assets (such as stocks and commodities) is bad news. The decline in the price of oil, if translated into its typical relationship to retail gasoline prices could translate to a $600 per family bonus. A little stimulus at just the right time.
The stronger argument for staying the course
At Astor, the current state of the US economy is the primary input into determining the optimal mix of stocks and bonds. As far as we can see today, the state of the US economy is strong. We see it in the strength of the labor market and the strong pipeline for manufacturing. If the economy begins to slide, we will adjust positions. It is possible the current stock market weakness foretells a recession, but in general using the stock market to predict recessions is a losing bet.
In addition to the real economy, we closely monitor the level of a much broader collection of indicators which measure financial stress. The well-known VIX is included in this mix, but so are several other measures. We collect these indicators into a daily index of financial stress. So far, this measure has not risen to the levels where evidence has suggested reducing exposure.
Our conclusion: Don’t Panic
Because of its association with outsized declines, it is uncomfortable to write in October that we expect today’s stock declines to be transitory, as a gut reaction says to head for the hills. Our research counsels a steady hand, however, and as long as the fundamentals do nott change, we will not either.