Global Headlines Hurt the Markets

Posted by Team HFM on October 01, 2014

It seems like the financial markets have been behaving themselves rather nicely for quite a while now.  Volatility has been low, the stock market has been in a relatively uninterrupted climb since December 2012 and interest rates, despite the hiccup in the spring of 2013, have remained low.

So what can a “paranoid” investor worry about?  Well, as it turns out, there are actually quite a few worries.  Just the fact that the market has been doing so well for so long worries some investors.  Others see dark clouds on the horizon in the form of Ebola, Vladimir Putin, the aggressive Russian president, ISIS’s growing strength, China’s slowing economic growth and increased militarism and Europe’s on again, off again recession just to name a few.

Yet there is a saying among investors that, “the market climbs a wall of worry.”  In other words despite the fear of many investors, strangely the market continues to rally.  There is a school of thought, with which we generally tend to agree, that the market is a giant voting machine that is actually quite prescient.  Thus the climb might be interpreted as the market voting against the worriers and predicting that the future is more benign than the “paranoid” fear.

Unfortunately, the market’s prescience is not perfect.  Thus the introduction of two terms, black swans and fat tails, into the general lexicon over the last few years.  Black swan was a term coined by Nassim Taleb in his book The Black Swan.  It describes the occurrence of unpredictable events that generally have a disruptive effect.  Often, after the event occurs, analysts can point to events that led up to the black swan with the implication that it could have been predicted.  The assassination of President Kennedy and the attack of the World Trade Center are good examples of such events.  So if there is a black swan in our future, it is unlikely to be on our current list of worries.

Fat tail is a term that comes from the arcane world of statistics.  It is basically a statistician’s way of representing the idea that bad events occur more frequently in the real world than the mathematics of statistics would predict.

Unfortunately for investors, fat tails do occur in the financial markets.  That is, bear markets have occurred with greater magnitude and frequency than the statisticians would predict.  Nevertheless, they have not occurred as often as near-average market returns do and, given the bear markets in 2000-2002 and 2008 many market participants overly fear that their frequency is higher than what has actually occurred over longer periods.

So what are “paranoid” investors to do?  Well certainly they cannot forget about their fears, justified or not.  What they can do is to build a well-structured portfolio designed to ride through the black swans and fat tails and take advantage of the opportunities that those events produce.  (Remember how cheap stocks were in 2009?)  In any case, if you are concerned about the markets, please don’t stew about them in silence, call us and discuss your portfolio to assure yourself that the structure fits your needs.