Market Commentary

Fear of Falling

October 2012

"It's not nice to fool Mother Nature!" - modern proverb,
from 1970s ad for Chiffon margarine

Many fears are learned from difficult experience. One that has been researched and determined to probably be instinctual is the fear of falling. We have written before that as we are creatures of nature, many of the social and economic phenomena we produce mirror those in nature. In this case, we think it's possible that our actions related to the fear of falling have taken us into a quite uncertain economic and market space. 

In the broad march of our economic history, we recognize that economic cycles come and go; indeed; they appear to bear a lot of similarity to cycles in nature. Growth accelerates, it crests, it overshoots, it corrects, and a rejuvenated base then begins to grow again. However, the more recent history of our economy, here and in Europe, has been overshadowed by many top-down attempts to eradicate some of this core cyclicality. Do all these attempts make sense? 

We think that here and in Europe, unprecedented intervention by the Federal Reserve and the European Central Bank to keep asset prices high is an extension of a phenomenon that has been going on for at least two decades. A recent study published by Federal Reserve economists notes that almost all the return in the U.S. stock market from the years 1994 to 2011 occurred in the days ahead of scheduled Federal Reserve public announcements (about twenty-four of about 250 trading days per year), with most of this asymmetrical return coming after the year 2000.ⁱ

We understood better the interventions that the Fed thought necessary in the fiscal crisis period of 2008-2009. We don't understand so well continued mass intervention now that broad confidence has returned. We wonder if it is a form of the natural fear of falling, writ large on the economic stage. We think it is creating instability – instability that we can't necessarily see. A pile of sand can shift underneath the surface, not visible to the eye – and yet, that shift can make an avalanche more likely.ⁱⁱ In our economy, we think these continued interventions, while well-intended, may make the surface seem more placid than the reality actually is. The placid surface in this case is an up market, with a lot of bullish sentiment, and the lowest volatility recorded since the sharp downturn we had from late 2007 on.

We continue to think that our underlying economic recovery remains quite fragile. Unprecedented speculative activity marked by lightning-speed computer trading makes the markets more volatile and more vulnerable than ever. Fundamentals in Europe continue to provide a measure of economic and banking instability and uncertainty that has a global reach. Most of all, the printing of paper money the world 'round gives us cause for concern about debt levels in the short- and long- term, and inflation in the long-term. Therefore we are managing your assets with a realistic expectation that the market will continue to be subject to sudden, volatile, and highly unpredictable moves. In the end, attempts to control the more naturalistic progression of the economic cycle may just make it more unpredictable. We may in fact be falling already, but we can't yet feel it.

This means that you remain, for now, underinvested in assets that are higher-risk and that in many environments provide higher return. We matured in this business analyzing stocks and owning them ourselves right alongside you and our other clients. We are very comfortable with stocks as long-term capital appreciation vehicles. We would really prefer to have you more fully invested in them. But, we expect more turbulence in the underpinnings of our investment world, and are playing more defense than offense right now. We really like these vehicles when they are cheaply priced, but in the unprecedented uncertainty of today's economic environment we see more risk than opportunity – and so for now we will proceed with caution.

Your managers have expressed some of the same sentiment in conversations with us recently  Most of your managers are not as fully invested in the stock and longer-duration bond market as they have been during the past few years. They have allowed shorter-term bond investments, some cash, gold, and gold-related holdings to build in their portfolios as they have found somewhat less to own that fits our common value discipline. This is to be expected and, along with our focus on defense at the fund selection and allocation level, has meant that you have underperformed the U.S. stock market year-to-date. While it is frustrating to lag in the short-term, we don't want to put the pedal to the metal at a time when we may need to have perfect timing to slam on the brakes ahead of whatever danger lies just around the bend. While right now that may make us seem like that annoying driver doing 50 mph in a 65 mph zone, we'd rather not subject you to the pileup.

We look forward to finding more opportunities at the right prices. 

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.

i Lucca & Moench, June 2012. The Pre-FOMC Announcement Drift. Federal Reserve Bank of New York, Staff Report no. 512

ii A good book on the mathematical modeling of these occurrences both in nature and in the stock markets is Mark Buchanan's Ubiquity: Why Catastrophes Happen (NY: Broadway, 2002)