Volatility Is Your Opportunity To Rebalance

January has delivered on our expectation for price volatility. At present, the market is giving us a little break from the selling. However, we expect we’ll have a couple periods of intense volatility in the first half of the year, and we don’t think it’s over yet. We’re not in the prediction business, but our experience tells us that a period of rising rates/ contraction of the money supply will have some typical characteristics:

Quick selloffs followed by “relief rallies,” where the market comes almost halfway back up.
An inability to set new highs in the short term.
An increasing number of stocks setting 52 week lows as the process drags on, rather than setting new highs.
“Margin calls,” where some investors are forced to sell investments when they’d rather be buying. They’re not stupid, but they owe money lent against investment prices that are falling and have to raise it by selling at the wrong time.
Some “90% down days,” where almost all stocks sell off and close near the lows for the day.
Harsh selloffs on lower quality investments. (What’s low quality? A bond with a lot of credit risk or shares of a company that doesn’t have a good balance sheet or strong earnings growth. Or you know, expensive memes.)
“Too low” prices on good quality investments that don’t “make sense” at the time.

Here’s a chart of the S&P 500 index fund SPY from 2018. The Fed raised rates 4x in 2018, and they also cut asset purchases. Similar moves are forecasted this year.

The original post showed a chart of SPY in 2018 here (source: Koyfin).

The market peaked in early Oct 2018, actually months after the first interest rate hike in March of that year. Once the market finally rolled over, we had multiple relief rallies (green arrows) but failed to set new highs. The market didn’t set new highs until about mid-April 2019, about 6 months later. The market didn’t turn upward in a sustainable trend until the Fed signaled that they were done raising rates in late December. In fact, at the time of the last rate hike on December 19, 2018, the Fed were signaling 2 more rate hikes in 2019 (CNBC).

This was not to be.

The selloff in stocks and a slowdown in home sales changed the thinking. When the Fed signaled that the rate hikes were enough, the trend changed. We suspect this year that the Fed will signal rate hikes until they get data that says inflation is slowing. We think that’s already happening.

We speculate that we will be in a period of volatility until the Fed changes their guidance. We suspect that the market will not set new highs with the pressure from the open question of how much rates will need to move up. So, we see the early part of the year as a time to position portfolios to weather volatility and to be able to buy assets on price volatility.

Looking back at 2018, it didn’t take all that long to have a positive rate of return on stocks purchased during the corrections, but it took awhile to get back to peak prices on investments owned prior to the selloff.

Some perspective

Get your risk levels right. Primarily this means the right balance between higher risk assets like stocks and lower risk, high quality bonds. We can help you score your portfolio risk with Riskalyze. What’s the right number for you?
See things in the larger context. When the market rallies in the early part of 2022, we think it’s your opportunity to rebalance, not the start of a new long term up-trend.
We think the trend will change when the fed outlook changes. Keep in mind, the Fed have gotten market interest rates and asset prices closer to where they’d like them to be without doing anything but talking about raising rates. If they talk about not needing to hike rates further, the sledding probably gets easier.
Price assets by traditional metrics, like Price to Earnings or Price to Earnings Growth. Old high prices and new low prices aren’t the guide to future valuations.
Act like you’re going to be alive awhile. Humans are warm-blooded creatures with enormous brains (specifically devoting a lot of resources to visual processing), relative to other animal species. This means we have amazing capabilities in the right conditions, but we’re not suited to living in the greatest range of environments. An alligator can go for a couple months without eating, submerged in bacteria-infested, muddy water. You, on the other hand, are hangry when you skip lunch. This tends to give us a very short perspective on relieving discomfort and makes it tough to have the longer perspective.

Why do we think we’re not done yet? Processes like this usually force out the speculative excesses in the market. There is still a lot of money being allocated to worthless investments, in our view. We think we will see good quality asset prices temporarily below what they’re worth, not at a reasonably fair value, which is how we see them at present. We may see certain aggressive and levered investments down more than 50%.

The key is to distinguish between quality and understand what price to pay. There are high quality investments that are also very volatile. Selloffs are the opportunities to build portfolio positions that were too expensive to buy last year. We encourage you to be investors, not traders.

We won’t be able to guess the bottom tick on the downtrend. We will probably have a pretty good idea when prices are attractive, providing an opportunity for return in the coming years.