Expert Tips on How to React to Market Volatility
For an insight into market price movements, managing emotions and keeping perspective during the current tumultuous times, we speak with Ron Medley, Bailey Wang and Dr Ned Gandevani from Moloney Securities Asset Management (MSAM).
Can you tell us a bit about the current state of the equity market?
Ned: There is a clear disconnect between financial markets and the economy. After a strong run-up for more than a decade, the stock market was prone to a pullback. The COVID-19 pandemic, as a strong exogenous factor, inflicted a sharp decline of 34% to the S&P 500 Index, a major market performance barometer, within one month. In other words, it took the market 10 years to make the new high of 3373.23 on 20th February 2020. However, within one month, the index fell to a low of 2237.4 on 23rd March 2020. As of 15th May 2020, the S&P 500 index has pared its losses to about 15%. The decoupling of the financial assets with the real economy can be attributed to the present high level of optimism among market participants for a quick economic recovery. The S&P 500 is a market-cap weighted index that includes most of the largest companies in the United States. The S&P market cap is 70 to 80% of the total US stock market capitalisation. It should be noted that nine stocks of the S&P 500 carry more than 25% of the index total weight. In other words, Mega-cap companies have been the main drivers behind the current unprecedented equity market bounce. Some mega-cap stocks almost appear immune to this pandemic, and their business has flourished – Microsoft and Amazon for example.
What’s your advice in terms of reacting to market price movements? How should investors respond to it?
Ned: The recent market volatility is a strong reminder for investors to construct a well-diversified portfolio. Moreover, when faced with severe volatility, they should stay the course by focusing on their long-term investment goals. However, investors must consider their liquidity status. According to the Bureau of Labour Statistics (BLS), the US economy lost over 20 million jobs in April with the unemployment rate spiking to 14.7% – the worst since the Great Depression. RBC’s estimate of the US GDP in 2020 is negative at -5.4%. Considering the unprecedented economic slowdown, investors are well-advised to secure sufficient liquidity to sustain their living expenses for at least 12 months until better economic visibility is attained in the future.
Investors should emphasise more on using fundamental analysis to select stocks for their portfolios. They should also review their asset allocations due to the possible prolonged economic slowdown. In a protracted low earnings environment, the passive investment strategy may be futile. Investors should utilise an active investment approach to identify the appropriate stocks according to their risk tolerance and investment goals.
Mega-cap companies have been the main drivers behind the current unprecedented equity market bounce.
This is also a good opportunity for investors to measure risk as well as returns. When comparing portfolios’ returns, they should use risk-adjusted returns for a better comparison. They should also consider using some performance measurement ratios to review their portfolios, such as the Sharpe ratio, Treynor ratio, and Jenson Alpha to compare and contrast their portfolios with others. As for their retirement planning and other future events, investors should adjust their estimates to match closely with reality.
How can investors use alternative feedback and strategy to inoculate against emotion and angst in the current volatile environment?
Bailey: We understand the day-to-day price volatility can cause discomfort for investors. However, investors should realise the market price does not necessarily reflect the intrinsic or real value of the stocks. When investors rely on the fundamentals for investment decisions, they worry less about daily price vacillations. At MSAM, we use different valuation models to estimate the real value of stocks. Our process seeks to identify a stock’s real value by analysing the company’s financial information, macro-economic trends, related regulations, and the behavioural components of other market participants. We also conduct a great deal of research to detect the underlying dynamics and trends in the market. Consider this, since the Dow Jones Industrial Average was published in 1896, 30% of the top 20 largest daily percentage losses are followed by the top 20 largest daily percentage gains within two weeks. Accordingly using the finding, while greater price variance can be difficult to experience, it can also present greater investment opportunities.
What’s your most important advice on what action investors need to take in order to ensure they handle the current situation in the best way possible?
Ned: To safeguard against emotional swings investors should have a well-diversified portfolio based on their Risk Tolerance. Many investors may be led to believe they hold a diversified portfolio. However, a closer look into the portfolio can reveal otherwise. When constructing a diversified portfolio, investors should consider the correlation coefficient of the stocks. In other words, if the stocks or other assets prices rise and fall with the market.
Moreover, understanding the portfolio’s risk is the key to investors’ emotional stability. Investors’ risk tolerance should be assessed based on their age, investment time horizon, income level, investment capital, and personality traits. Investors should use a methodical and valid instrument to ascertain their risk level for constructing a sound portfolio.
The recent market volatility is a strong reminder for investors to construct a well-diversified portfolio.
Bailey: Rather than focusing on day-to-day price movements, focus on the long-term objectives of the portfolios to deliver the competitive risk-adjusted returns.
How important is it to develop an investment decision-making process with multiple layers of feedback to inform investment decision-making?
Ron: During market volatility, many investors wish they had the opportunity to speak with their portfolio managers directly. They seek direct advice to reduce their anxiety about the current market wild swings. One of the advantages of investing in MSAM’s portfolios is the ability for investors to contact the portfolio managers with their questions. We encourage investors to build a relationship with their professional investment managers.
Additionally, I echo Ned & Bailey’s recommendations that investors should stay the course during the market volatility periods and develop sound processes. Thinking about how some of these ideas fit together through time, I’m reminded of some reports I read from the Great Depression era. The following statements were published by Moody’s Investors Service over a two-year period:
- 6th January 1930: “The last half of 1930 should be marked by rapid recovery in every direction.”
- 5th January 1931: “We consider stock prices, on the whole, to be well deflated, but do not look for any very early or sustained recovery.”
- 28th December 1931: “We are of the opinion that the prospects are not such to warrant the buying of common stocks.”
Interestingly, about six months later, on 26th May 1932, the Dow Jones Industrials added three companies to the index: Coca-Cola, IBM & Proctor & Gamble. The bottom in the Dow Jones Industrial Average was less than two months later on 8th July 1932.
In real-time, we don’t know the depth, diffusion and duration of an economic downturn. But currently, with trillions of dollars of stimulus and support from the government and Federal Reserve, systemic risk is not in question. Business will go on but the companies leading the way might change, as in 1932. When investors devise an optimal portfolio based on their investment goals and risk tolerance, use multiple layers of feedback and professional relationships, they can focus on their long-term goals to weather the current market swings.
Ron Medley is the President of MSAM in St. Louis, Missouri. Bailey Wang, CFA, CPA is a Portfolio Manager at MSAM. Ned Gandevani, PhD, MBA, is a registered rep and investment adviser with MSAM and serves as a Senior Portfolio Manager within the company. He currently teaches at Harvard University.
For more information, go to www.msam.net