The Pit and the Pendulum
January 21, 2015
In the above titled short story, an unfortunate prisoner has to endure two different types of torture. Readers who search for symbolism may likely view this tale as a figurative journey into the psychological depths of decision-making during stock market tumult. Unfortunately, after hundreds of seconds of internet research, I was able to confirm that Edgar Allan Poe died young (age 40) and poor. It is therefore questionable whether Poe intended to write an allegory about Wall Street with his macabre tale. But intended or not, the connection is clear.
As a quick review, the story is about a prisoner, during the Inquisition, who wakes up bound and laid beneath a large razor sharp pendulum that lowers with each back and forth stroke, assuring death by slicing. He ingeniously rubs food on his binds, which are eaten by rats, thereby freeing him before the pendulum kills him. Unfortunately, trouble continues when the walls of the prison become red hot and slowly converge to the center of the room, where there is (you guessed it) a deep pit which will become the prisoners tomb. Just as the man is being forced into the pit by the hot, closing walls, they stop moving and an arm of a French soldier saves him from death.
The intriguing connection between the pendulum and stock market cycles is clear. All investors apprehend the ongoing cyclical nature of stock market movements. Bull, bear, bull, bear. They realize that at some point the next bear market will start, but exactly when, why and how deep are always the questions. The fear Poe deals with is usually fear of death, or pain. In finance, it is usually fear of losing money or not meeting your goals, which can be just as painful.
Sometimes investors’ fear transcends bull and bear cycles with a perception that certain economic fundamentals have changed so much that it is no longer possible for capitalism to continue to work. This often leads to “generational” bear markets, and involves the highest amounts of fear, which lead to the deepest plunges in the markets. One example occurred during the 1973-74 bear market. During that time, interest rates were at multi-decade highs. The Mideast energy crisis was in full swing, as evidenced by the first ever “odd/even” gas line days. Lastly, President Richard Nixon used his executive order power to do away with gold backed US currency and to enact corporate wage and price controls in an attempt to stop hyperinflation. This type of government intervention spooked the markets, as many investors felt capitalism was broken, if not dead. During the great bear market of 2008-09, similar issues occurred. Century old financial institutions were closed by the Treasury Department. AAA rated mortgage-backed securities became worthless overnight. Liquidity in many income markets disappeared and the US government had to guarantee most privately held money market funds for fear of a public run on them. The health of capitalism was brought into question once again and investors sold off the markets in a manner similar to the 1973-74 bear. In both of these periods, fear gripped investors, as they became convinced the economy would fall into the “pit” and never rise again.
Whether they realize it or not, investors are always subconsciously thinking about possible “pits” or “pendulums” when making decisions about their portfolio. Downward market volatility always has the potential to lead to one of these two outcomes. Because of the fear involved, many investors often make poor decisions. Unfortunately, this has been discussed many times in this quarterly report; these poor decisions virtually insure unsatisfactory long term investment results.
Here is a recent example. In the third quarter of 2014, for the first time in over two years, the S&P 500 Index experienced nearly a 10% correction in a short period of time. Specifically, it fell from its all-time high on 9/19/14 to a 9.8% lower price on 10/15/14. During or after this drop, many timid investors decided to sell and wait out the volatility on the sidelines. Unfortunately for them, 14 trading days later the market had moved back up and made a brand new all-time high. Many investors didn’t experience that bounce, because they were not in the market. It turns out that missing a very few of the best daily returns can have a substantially negative effect on your long term returns. See the chart below.
This chart, prepared by J.P. Morgan Asset Management, shows that missing the ten best trading days over the last 20 years would have reduced your return by almost half. The problem with this is that often these best 10 days are happening immediately after bad days. Wikipedia shows an excellent compilation of data dealing with this effect.
- The worst market performance day in the last 20 years is followed by a 5.33% UP day.
- The 4th worst market performance day in the last 20 years is followed by a 5.42% UP day.
- The 5th worst market performance day in the last 20 years is followed by a 4.93% UP day.
- The 7th worst market performance day in the last 20 years is followed by a 5.12% UP day.
- The 8th worst market performance day in the last 20 years is followed by a 5.09% UP day.
- The 10th worst market performance day in the last 20 years is followed by a 6.32% UP day.
In other words, the only way an investor could have been in these great UP days was to have been in the market the day before, when they would have experienced the other side of the market’s pendulum. That is very difficult for many investors to do. The fear of the dark side, the dreaded Pit of the market is the very thing that usually guarantees that skittish investors will dramatically underperform the rates of return they should be earning.
DHG Wealth Advisors help our clients combat this phenomenon in two ways. First, we build portfolios that closely match their desired risk appetite. We carefully work with our clients to give them ideas of just how poorly their portfolio may react to certain bear market trends. By showing these worst case comparisons, we hope to give them an idea of just how bad it has been, and can again be, during the worst of the bear markets. We then use this information to assist in building proper risk parameters into their portfolios. Second, we help add discipline to the investment process. It doesn’t help to have a well thought out plan if an investor does not remain restrained and in control when times get tough. A combination of these two methods will add bravery during “pit and pendulum” times. In this way, we can help insure that the only horror you will experience may be in your enjoyment of scary fiction and not from your monthly brokerage statements.
Fourth Quarter 2014 Asset Class Returns
The fourth quarter of 2014 was strictly a study in geography. All domestic asset classes had positive returns. Small Caps had a strong bounce after a poor third quarter showing, but Real Estate continued its yearly triumph by posting the only double digit quarterly return. Foreign markets, both Developed and Emerging Markets, had negative returns. The cheaper valuations of those markets were not enough to make up for the much weaker economic fundamentals and strength of the US dollar. Consequently, differences in annual returns between the Domestic and International equity asset classes were hefty, in many cases from 15% to 20% greater for US based equities.
US Large Caps had strong double digit annual returns, while Small Caps varied from higher to lower single digits. This is an interesting occurrence, because historically, Large Cap is a lower performing asset class, if only because the size of the companies make it more difficult to increase earnings as quickly as smaller companies. It also means that properly diversified portfolios will underperform Large Cap indices such as the S&P 500 Index during these shorter time periods. Don’t let these anomalies distract from your goal of long term outperformance via proper diversification.
The gradual lowering of interest rates throughout most of the year insured that bonds, especially long term and high grade, had high teen total returns. This seemed to thumb its nose at the typical Wall Street view that bond prices would drop due to the Fed’s shuttering of the QE artificial stimulus. But the big winner was Real Estate, which easily outperformed all other asset classes with a 30% annual return. One has to wonder just how much more outperformance can occur before a healthy correction takes place in the REIT market place.
The global economy continues to give investors a choice. On one side, the US economy is clearly the leader, with employment, corporate earnings, GDP growth and US Dollar clearly stronger than their developed foreign counterparts. Market valuations are clearly higher in the US as well. At some point, the lower valuations of both foreign developed and emerging market countries may make up for their much slower, and in some cases, sicker economies. Clearly, in 2014, global investors chose US stocks, and were rewarded. How that choice will turn out in 2015 is less clear.
In addition, there are still numerous risks that could bring volatility to the markets. The sliding price of oil, the beginning of international cyber warfare, the Fed’s continuing balancing act between growth and interest rates, Russian aggression, certain emerging market countries’ currency crises, Ebola, and finally, ongoing potential terror threats round out a list of conceivably worrisome issues upon which you can hang your hat in 2015.
For the long term investor, there will always be short and long term fears that have the potential of coming true and starting the next major downswing. It is part of the process. As always, the way to handle these issues is by owning a scientifically diversified portfolio, which will insure that you own asset classes which will be winners at certain times during the full market cycle. In addition, our clients own low cost, institutional fund vehicles that are both complete in their asset class representation and tax efficient due to their passive management. We cannot guess the future, but we can insure that you will take advantage of attractive rates of capital return for the risks that are taken in your portfolio.
The New Year is certain to bring interesting political and economic events to hold our interest, and perhaps test our resolve. Make sure you stay healthy and warm, and we’ll touch base again in the springtime to see how these outcomes have transpired.
Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC