Thinkpiece

25 Jan Thinkpiece

If it escaped your attention that investment markets have been volatile over the past few weeks, then congratulations to you…..one of the key attributes of a successful investor, and retaining one’s financial independence, is not to look at your investments too often. If you’ve set the strategy correctly with your adviser, bought quality companies within an appropriately diversified portfolio, then once a year is enough.

If you can enjoy Saturdays and Sundays without looking at stock prices,
give it a try on weekdays.

Warren Buffet

Investment markets follow the themes and events around the world. In investment markets, when the story changes, so does the price.

The difference with investment markets, is that often the driving forces behind market prices are intangible. We feel the effects of them, inflation for example, but we can’t see them, only their effect.

UK inflation was surprisingly high in December (the headline consumer price index hitting 5.4% year over year). Globally, it is currently anticipated that inflationary pressures will ease over 2022, as some of the factors associated with the reopening dissipate.

The key question that markets are trying to price-in currently is ‘When and how fast does inflation fall and where does it stabilise?’

We won’t know the answer to that until the answer is evident! So, in the interim, like the patient lying on the hospital gurney with their vital signs creating all sorts of irregular beeps and numbers on diagnostic equipment, so the markets respond in the same way. We call this volatility.

Remember, that volatility is not loss. Referring only to those that hold well-researched quality companies within their portfolios (and certainly not those that have made speculative plays in cryptocurrency et al), if one is tempted to react to ‘the current story’ by selling one’s holdings for fear of losing more, then you will fulfil J P Morgan’s prophecy that “In bear markets, stocks return to their rightful owners.”

We’re not quite in bear market territory yet (a bear market is defined as a period when security prices fall 20% or more from their recent highs), but the sentiment is clear.

If you can’t stomach 50% declines in your investment you will get the mediocre returns you deserve.

Charlie Munger

Stock market volatility is perfectly normal and expected. It presents a significant opportunity to the investor, but you won’t feel like it’s an opportunity when you’re in the middle of headlines such as:

‘Risk appetite hurt by Ukraine fears’ 

‘Fed uncertainty adds to US dip buyers’ risks’ 

‘Stocks sell off amid geopolitical tensions, Fed rate hike fears’ 

‘£n billion wiped off the value of stock markets’

Volatility is the price of admission. The prize inside is superior long-term returns.

You have to pay the price to get the returns.

Morgan Housel

These headlines are there to do one thing, and one thing only – to sell media. Turn off the noise – the media. We’re drowning in excess information. Much of it, low quality. The authors of this low-quality information know that fear hooks people’s attention. Today’s problem is an excess of information. Curation is important for your own sanity and state of mind.

 As an example, look at the volatility in the UK stock market during the commencement of Covid 19, and the benefit of staying the course.

A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. You need to keep raw, irrational emotion under control.

Charlie Munger

If you want to have what others don’t, you have to do what others are not able or prepared to do, and in investing terms, that means to stay the course.

That’s not what the media will be telling you.

Short-term market volatility has about as much relevance to your long-term financial plan, as the weather forecast 5 years ago had to today.

The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioural discipline that are likely to get you where you want to go.

Benjamin Graham

What is fuelling volatility?

The reason for heightened market volatility at the current time is because of the threat of higher inflation persisting for longer than policymakers would ideally like, whilst at the same time, central banks (in particular the Federal Reserve) are seeking to draw in the amount of asset purchases that they make every month, leading to less liquidity in the markets. The aim of reducing the asset purchases is to try to mitigate higher inflation, but this can take up to 18 months to start to have an impact.

Supply chain disruption also creates limits in the supply of goods and services. In addition to this, as a legacy from the disruption from covid, with people stuck at home, they have saved more money as a consequence. They are now ready to spend it. With the increased demand and the limited supply, this increases prices.

There is strong demand in areas such as consumer goods, and in particularly durable goods.

In the UK, with the price cap on energy bills is expected to increase by about 50% in April, there is likely to be further upward pressure on inflation in the near term.

Fortunately for consumers, tight labour markets are supporting strong wage gains. While these will ease the pain over the coming months, they could also fuel a longer period of above target inflation. Against this backdrop, the Bank of England may increase interest rates in February.

Markets have anticipated these increases, to some extent. The Fed (Federal Reserve) has taken notice of higher inflation and signalled its desire to raise interest rates sooner than originally anticipated. Should inflation stay at higher levels than desired, then they may increase rates once a quarter thereafter.

Value or Growth stocks?

The story of investing in the 21^st century to date has been growth investing. Growth stocks are companies that are expected to grow sales and earnings at a faster rate than inflation. If inflation is pegged at 2%, as it has been for a long time and remains the target for western economies, then with these low interest rates, forecasts for earnings will look much better than they will with inflation at 7%!

The alternative to growth stocks are value stocks. A value stock is a security trading at a lower price than what the company’s performance may otherwise indicate. They become more attractive during periods of rising interest rates and inflation.

Diversification

Diversity is important, because no matter how much we think a particular thing will happen, invariably the markets will turn in a different direction. This cannot be predicted.

When inflation rises, valuations for growth stocks will be revised downwards. This gives an opportunity for your fund managers to buy-in at these temporarily reduced prices. The secret is not to react to current market valuations by bailing-out.

A good array of appropriately diversified and well-researched fund managers are perfectly capable of benefitting from market volatility in the long term. What they can’t control are systemic risks such as political issues (the Ukraine for example) or other unexpected events, such as the disruption caused by covid.

No one can predict in advance which markets will do well and which markets will suffer. This is why we advocate diversifying appropriately across different asset types (equities, bonds and cash) as well as different economies (US, UK, Asia, Europe, Japan, etc).

You can plan for a hundred years. But you don’t know what will happen the next moment.

Neem Karoli Baba

It is therefore sensible to hold a diverse portfolio of holdings (but not too diluted), spread across many sectors and economies, as well as stock types and asset classes, whilst allowing fund managers to adapt the strategy in anticipation, as the story unfolds.

It’s about looking ahead, as Warren Buffet espouses.

Games are won by players who focus on the field, not the ones looking at the scoreboard.

Warren Buffet

The Outlook

The medium-term outlook is encouraging. We are not seeing a lot of evidence that services inflation is accelerating, and currently higher wages are not yet fuelling higher prices.

Much will depend on what happens to economic growth and the covid variant over the coming months. Inflation rates could decelerate sharply in the second half of the year, so it is a difficult balancing act in the meantime….but it always is.

As mentioned before, in the short term, this all leads to increased volatility.

Markets always climb a wall of worry.

The well-documented supply chain problems may linger for some months but whether this turns into a lasting inflation problem partly depends on the jobs market. If workers are able to bargain for higher wages in the face of rising living costs, then this has the potential to feed a wage-price spiral and medium-term inflationary pressure.

Some companies and investment funds will react positively or negatively to this news, depending upon the type of company or fund.

Emergency Fund

Never underestimate the importance of having a healthy emergency fund.

If you are drawing down on your portfolio to support your standard of living, then this is an opportunity to stop or reduce those withdrawals during this temporary market downturn, and to draw on your emergency fund.

You don’t want to harm or kill your golden goose.

When markets recover, and they will recover, then you can then turn back on your withdrawals from your portfolio, and begin to replenish your emergency fund, whilst benefitting from higher stock prices. Your goose will be much healthier as a result.

Summary

• To the experienced investor, volatility is expected and normal
• Ensure your portfolio is well diversified, but not too diluted
• Don’t react to market sentiment – or dress today for old weather forecasts!
• Work in conjunction with your financial planner to construct a robust plan

The views expressed are not to be taken as financial advice. Professional advice should be sought before proceeding.