If you’re watching CNBC, Bloomberg TV, reading Barrons or the Wall Street Journal or even just cruising Google or listening to the pundits anywhere else this past volatile week, you’ll know that this last round of sudden volatility is mostly being written off as a “much needed market correction” in an ongoing Bull Market. Unlike the recent few market convulsions, there are no obvious villains to point at. There is no Peso problem, no “fat fingered flash crash”, no DotCom Maniac to blame, no Junk Bond market manipulator and no evil sub-prime greed at work. Even the much despised “high-speed traders” and “heartless hedge funds” aren’t being blamed for this particular scare and for the most part, the experts don’t seem to be blaming Trump or Pelosi either. Indeed, most pundits seem eager to assure us that it’s just “a much needed correction in the bull market.”
But we humans have an amazing ability to see the patterns we want to see, and to construct brilliant and eloquent explanations in hindsight.
So, I have a TV-watching assignment for you. I’d like you to watch a TV show that I used to watch religiously while I was a much younger man, just beginning to get interested in our financial markets. It was the late ’80s, and I was a graduate student with no investable wealth to speak of. All the same, one of my favorite TV shows at the time was the widely watched “Wall Street Week with Louis Rukeyser” on PBS and my personal favorite guest on that show was a soft spoken friendly sounding guy named Marty Zweig. Since my graduate student stipend did not permit me the luxury of a VCR, I spent many weekend mornings eagerly listening to the embarrassingly pun-addicted Louis Rukeyser and the gentle thoughtful commentary of Marty Zweig. At the time I began watching Wall Street Week, around 1989, the Stock Market crash of 1987 was still a very recent memory and Marty Zweig was widely known as “the guy who had called the crash of ’87” on the episode of Wall Street Week that aired the Friday prior to Black Monday.
That incredible episode of “Wall Street Week with Louis Rukeyser” where Marty Zweig so presciently “called the crash” is still available today on YouTube, and I urge you to watch it. It’s in three parts, and Part One is here and also embedded on this page … I dare you to watch that first 10 minute segment and not get at least a tiny chill up your spine.
I really do want you to listen to Rukeyser’s opening, so I won’t describe it for you here very much. But, note that he opened that show on Friday evening after what was, at the time, the largest single point drop in the Dow, and a week of unprecedented volatility. He attributed this, among other things, to rising interest rates, political unrest (in the Persian Gulf), failed leadership in Washington (by both parties), a new tax (increase) package he feared would penalize investment and savings, reports of layoffs on Wall Street, “the mindless computer driven program trading” and a growing trade deficit. He noted that Wall Street seemed to be ignoring “reassurances about the economy from Treasury Secretary James Baker and Federal Reserve Chairman, Alan Greenspan“. Anything ring familiar?
Rukeyser did have some consolation for the viewer that Friday in October 1987: “Don’t forget how high these averages are,” he said. “Today’s record point loss, for example, was, on a percentage basis, only #76 on the all time list of bad days for the Dow.” A mere seven days later he would look back on that week as “the most unusual in all the millenia of investing“.
After all, this was still the Friday before Black Monday, the single worst crash in stock market history since the Great Depression.
But let’s get back to that episode, and to Louis and Marty. When Rukeyser asked him if he thought if the bull market was dead, Marty Zweig responded simply, “Yes“. He then went on to warn about upcoming volatility and even some “violent rallies” but Zweig was absolutely unambiguous about his expectations of an imminent crash. It is chilling to watch, in hindsight, even 30 years later.
But I want you to keep watching after Marty has his say. Next up on the panel after Marty, was the ever eloquent Mary Farrell. When asked her opinion she very clearly and calmly argued against a crash adding “And, I wouldn’t accept the estimates that the Bull Market is over either.” Last up was Lou Holland who said “I’m more positive, I think, than either Marty or Mary“.
Again, this is on the evening of Friday October 16 1987 – the Friday before Black Monday, when the Dow Jones Industrial Average fell over 22% on that one day. Today, that would be a drop of around 5000 points in a single day.
Are we heading for a crash?
My point is not to say that we should expect or even fear an imminent market crash. There are just as many differences today from October 1987 as there might be similarities, and the markets of 2018 are dramatically different from the markets of 1987. There is no Persian Gulf style conflict imminent, the economy probably is a lot stronger and we’re talking tax cuts, not tax hikes. However, what I am trying to say is that even the market’s most experienced experts are frequently dead wrong, and I take no solace in predictions about the market itself, no matter how experienced or scholarly the prognosticators.
So what is an investor to do?
Stay diversified. If you are long the market, as most of us should be, the truth is that you will likely see a fall in the value of your portfolio in the event of a market crash. Get used to this idea. Embrace it. And make absolutely certain that you size your equity allocation so you won’t have to sell into a crash. As John Templeton would say just one week later: “If you don’t have borrowed money, you don’t have anything to worry about.”
Why subject yourself to such torture? Because, eventually, markets will recover. And when it does, is just as unpredictable as when the crash occurs. Decades of academic and practitioner research points to the fact that predicting the timing of a resumption of a Bull Market, or timing its recovery from a crash is just as hard as predicting the timing of the crash itself. So, for the capital that you have decided to invest in the market, all you can do is, diversify, diversify, diversify. Make sure that you have used every tool at your disposal and that you have squeezed every last drop of diversification potential from your portfolio.
At Optimal, we choose to build our portfolios by systematically and scientifically diversifying at every possible stage – first within each factor sleeve and then across factors. Our experience suggests that this pays off when you need it the most. Over this recent volatile drop (from Monday 1/29 through Friday 2/9), as the S&P500 dropped over 10 percent, I was gratified to see that every single one of our factor premia sleeve models as well as every one of our live models significantly outperformed the benchmark (see TABLE below). Exactly as one would expect, the Low-Vol portfolio sleeve behaved the best, outperforming the S&P500 by 1.39%, but beyond that, both of our flagship live strategy models outperformed the benchmark by over 1% (1.03% in the case of Premia Harvest and 1.42% in the case of Dynamic Alpha). Should the markets drop again, I won’t be panicking because I’d expect that our diversification strategies should help limit the damage, and will allow me to stay invested while I wait for the markets to turn back around whenever they do.
Who do you trust?
So if you are tempted to be swayed by the pundits on CNBC or Bloomberg or anywhere else, take a moment to travel back in time and watch the pundits on TV on the Friday before the most devastating stock market crash since the Great Depression. Once you are done watching, ask yourself – “Just how much should I trust these opinions?”
Me? I chose to ignore the Opinions and rely on my Optimizer instead. I choose to trust the Science rather than the Sentiment. I pick Discipline rather than tune in to the Discussion. And, I diversify, diversify, diversify.
Watch the Friday October 16 1987 episode of Wall Street Week with Louis Rukeyser here.
Vijay Vaidyanathan, PhD is CEO at Optimal Asset Management and Research Associate with EDHEC Risk Institute, Nice France. Optimal Asset Management is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940, as amended.
|Premia Factor Sleeve Models||OAM Model Strategies|
|Low-Vol||Quality||Momentum||Value||Premia Harvest||Dynamic Alpha||SP 500|
|Return 1/29/2018 thru 2/8/2018||-8.73%||-8.87%||-9.07%||-9.70%||-9.09%||-8.70%||-10.12%|