Stocks around the globe saw percentage losses from the mid teens to low twenties in the third quarter, while the dollar and Treasuries climbed as investors fled to safety.
Two themes we have written about frequently since we began to emerge in 2009 from what has been termed “the Great Recession” continue to be relevant. First, we made the point that this is not like other business cycles. The huge debt load that precipitated the 2008 financial crisis will take many years to work through, and during that time we expect economic growth to be well below the levels seen in past recoveries (as has been the case so far). Second, as financial markets recovered and investors flocked to riskier assets, we pointed to significant risks, such as Europe’s debt problems, that continued to pose threats to the global economy and financial markets.
During this period since early 2009 equities rose sharply – in effect borrowing from future returns – and given our expectation the global economy faced significant headwinds and risks, we deemed it prudent to take some equity risk off the table last quarter. In short, we felt that any missed opportunity from having less equity exposure was likely to be modest relative to the “insurance” in the form of downside protection in the event any of these risks, or fears of them, were to drive markets sharply lower.
Though it’s been an eventful and highly volatile quarter, nothing is really new in terms of our broader analysis. What is new is that markets took some time to digest and react to the likelihood of slower global economic growth. This has contributed to stocks and other riskier assets falling in value – in a sense resetting to a lower level to take this slower growth (and possibly a near-term recession) into account.
Meanwhile, several of the big-picture risks we’ve been writing about also became widely recognized and led to an increase in fear, and this has pushed prices down as well as increased volatility to record levels. One risk is the likelihood of an eventual Greek default, and the impact this would have on other eurozone members, both weak and strong, and on European banks. Markets hate uncertainty, and it is very difficult to determine how this will play out – hence the extreme volatility we’ve been seeing.
Where does that leave us now, and looking ahead? Ironically, concern about a U.S. credit downgrade contributed to risk-averse investors’ flocking to Treasuries. In September we saw market declines bring stocks to levels that suggested longer-term returns were significantly better. With our eye on long-term gains, we slowly began putting money back to work in equities. We know that this can increase short-term risk at a time when it feels most uncomfortable, but being successful in the long term requires buying when valuations are more attractive, which means following a decline when headlines are most disturbing.
We think we do a very good job analyzing and weighting possible outcomes, but it’s worth a reminder that no one knows for sure how things will play out. We want clients to know that we are making our allocations based on thorough, careful analysis, taking risk and return into account. But we aren’t investing based on the worst-case scenario because we would be giving up too much return in order to protect against what we consider to be an unlikely outcome. We value your confidence in us and we welcome the opportunity to discuss any of our portfolio strategies with you.