Today (Jan 3rd) I sent an acquaintance on LinkedIn the following note regarding recent market volatility:
Sorry for the delay. Copying *****, as he might like to read.
You asked if I am surprised by recent market volatility. Short answer: no. Below, I have summarized how I think about volatility with respect to my background, my philosophy, recent market events, and my clients.
I worked in commodities from 2000 through 2014, which I punctuated with an MBA stint in 2006-2008. In that time, I experienced not only the Dot-Com crash and the Housing/Financial Crisis (both on the heels of fresh degrees – what luck!), but also the wild vicissitudes of the energy markets. (Electricity and natural gas can be the most volatile traded instruments due to storage issues.) I have a firsthand account of trading during the California Power Crisis, the New England blackouts, US Hurricanes, Fukushima and countless other energy-related issues. But, I realize big volatility isn’t exclusive to energy markets.
Markets are a fast way for two parties to agree on a standardized product in a way that suits both best at that moment. If the product is understood well enough, the two parties don’t even have to speak the same language. Markets allow a global, 24-hour, common dialogue about labor, resources, and other economic conditions. Just as you adapt when you talk with someone, humans adapt globally as prices change.
This ‘market dialogue’ is expanding. There is a triple-compound effect here with (1) increasing market participation – for example, formerly communist countries turning capitalist; (2) population growth; and (3) increasing longevity. More human brains are helping set prices than ever. All of those brains are using and improving technology, which leverages the compounded effect further.
With the exponential leaps that are occurring in technology, markets are becoming ever more efficient. I am not just referring to AI, big data, cloud computing, blockchain or today’s tech zeitgeist. Those relatively recent developments are important, yes, but I am talking about history over the last 70 years or more. Markets continually adapt faster, for a broader array of problems, than most people are mentally prepared to accept.
At the same time, we humans are emotional creatures — we repeatedly react poorly to rapid changes in information. A constant is that some of us are always under-prepared for the unforeseen. Also, a new twist is that we are still learning to deal with the fact that everyone has an internet megaphone. We herd. We trade with emotions. Markets overshoot. Volatility results. Yet, volatility helps us reset and reallocate.
The Powell-led Federal Reserve reacted poorly to changing conditions in 2018, especially in Q4. The markets were already primed for a hangover after the stimulus of the 2017 US tax-cut and decreased liquidity from global central bank balance sheet shrinkage. The Fed was much too intent on *demonstrating* they are fighting rising inflation. The market panicked when the Fed reacted too slowly to a rapid decrease in inflation in Q4. I think (or hope) the Fed will be less complacent in the coming year.
The tariff situation is also bad news. When you go to war with an enemy, you try to deprive the enemy of resources. Tariffs aren’t blockades, but they are on the spectrum (of resource deprivation and therefore war). See the Wikipedia article for Smoot-Hawley. If your goal is to achieve a positive economic outcome, then enacting tariffs is counter-productive to you.
Trump’s limited war is asymmetric; it is a negative for the US and potentially catastrophic for China. China has numerous other problems which will be exacerbated by lower trade. This is a known known. Trump is a pragmatist, he knows he has the Chinese somewhat cornered, and wants to campaign next year with a win on trade. He is also very unpredictable. The known unknown is how far Trump will go to achieve his win. My baseline is for the tariff discussion to fade soon, but who knows?
The US economy is not currently recessionary. Yet. The market has now priced in a sluggish Fed. Both Trump and the Chinese are incentivized to resolve the US tariff for political reasons. The market can bounce like 1994-1995 after the Fed stopped raising rates, or in 1998-1999 after global economic issues abated. History can and does rhyme.
If these or other things don’t happen like we want, the US will tip into recession.
Anything can happen. I constantly think about risk and reward for my clients. I do not define risk for my clients in terms of volatility – volatility is a flawed risk measure. Market volatility is not necessarily a bad thing.
Peak-to-valley portfolio drawdown is a preferable and less-flawed risk measure. If indicators flash a recessionary condition, I will cut client risk and try to limit large drawdowns. Managing a portfolio for expected drawdown is more optimal than managing for expected volatility.
Until I see evidence of a recession, my default setting is optimism and I will stay the course. The future is going to be better than the past, with hiccups along the way. I can’t predict what will change, or how much we, as a whole, will react.
Market volatility is the noise level of the global marketplace. A feature. We have a tendency to pay more attention when volatility increases. This heightened risk awareness and preparedness is good. However, we shouldn’t let that overshadow the growth and adaptation silently occurring around the world.
To put a point on it, I note that Apple is down a lot today (-10%). If Apple announces a flexible, waterproof phone tomorrow, then today’s decline may pale in comparison to the bounce!
Sprout Capital Management, LLC
January 3, 2019
*Note: I do not currently recommend Apple as an investment. Neither I nor Sprout-directed client portfolios currently hold a position in Apple at the time of this writing. I only use Apple as an example.
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