A sleeper hit movie released several years ago, “Sideways” followed the misadventures of two oddballs who could not have been more different. What was supposed to be a week of golf and good wine — two old college roommates having a nice time before the wedding of one of them — turned into something quite different. Both of them traveled from the heights of ecstasy to the depths of despair (really!), only to end up making some modest progress along their respective life journeys.

And so it goes for us. We couldn’t even sit down to write the year-end letter before the S&P 500 fell on each of the first five trading days of 2016, down 6% overall — the worst first week ever.1 Now, it is close to last August’s low; the Dow is down more than 1,000 points, as well.

So what’s with “Sideways?”

A “sideways market” is one that moves up and down over time, but makes little net progress. Imagine the line chart going up and down and ending up more or less in the middle, back to where it started. Add a little extra volatility, and that’s what we have had on our hands this past year or so. Interesting…the period just before a presidential election is often a time when markets do very well. Certainly not this cycle, not so far — up and down, down and up.

Sideways President's Letter

You can get whiplash from tracking the market up and down, and it can get very expensive if you try to react to those movements. Just when things look good, you jump in, and they go down; out you go, and back up goes the market. I don’t recommend going for that ride.

What can we learn from the past about volatile markets and sharp ups and downs?

I am reminded of three big events from the past, all of which proved that discipline really works:

  • Buying in after the famous crash of October 19, 1987, meant you enjoyed a very nice recovery — over 16% the following year and over 30% the year after. The fearful missed out; that is easy to say, but I remember it like it was yesterday, and the fear was widespread and palpable. I felt the shock for months.
  • Through March 2000, not buying in, but selling equity to rebalance and stay on target and not chasing tech/large-cap growth meant you avoided most of the catastrophic losses that followed in big-tech stocks. Resisting that feeding frenzy was extremely difficult; many succumbed and paid a high price.
  • In March of 2009, buying equity (to rebalance back up to target) at the point of “capitulation” positioned you for the very sharp recovery all the experts guaranteed was impossible — much like 1988-89 all over again. But doing so was very hard; by then, many feared for the very future of our financial markets.

Greed and fear, headlines, prognostications…it’s always the same story in the end.
The bad advice is to give in to your emotions and do what has worked well most recently, as if these things did not run in unpredictable and often volatile cycles.

Another good example of this is the recent underperformance of small and value stocks relative to large and growth stocks. Over recent periods, a small number of large growth stocks have reversed the long-term pattern and have outperformed small and value stocks, raising questions in the minds of some. The answer is that this happens from time to time, but does not persist indefinitely.

So don’t load up on Netflix and Amazon just yet! And let’s not fall victim to fear and greed; don’t let these gyrations shake you loose — that’s what discipline is.

Today’s big issues: China and oil, and corporate profits

Good jobs numbers the other day, on the surface — but underneath, not so good. The old and the young, likely part time. Wages down, not up; not much growth. Unfortunately, we are nowhere near enjoying a strong recovery and putting middle-class Americans back to work in good jobs. But the U.S. is still the cleanest dirty shirt in the hamper; the rest of the world has it worse.

China, as we have discussed in several recent letters, has major problems to go with its opportunities. Right now, a mere slowdown in growth is creating some panic, but that reaction is as inappropriate as the frenzy that preceded it. China will neither collapse in a heap nor dominate the world anytime soon, although the potential for serious trouble is certainly part of the equation. Stay tuned.

Corporate profits in the U.S. — the one bright spot in the past few years — have slowed. The worst results are coming from the Energy sector, of course, as the collapse in oil prices has negative short-term impacts on the economy, on equities and on high-yield bonds, too; energy companies finance a lot of their activity with high-yield bonds.

But lower oil prices have a very good side: globally, the cost of energy is very low.
And if it goes higher, the U.S. is now positioned to not only provide for its own needs, but to export energy in a big way. Good news.

Equity valuations have dropped. While not cheap just yet, equities are more reasonably priced than they were a year ago, and the yield on equities offers a nice premium over bond yields, another sign that prices are at least reasonable. Good news.

Meanwhile, bonds, despite the Fed tightening and the widespread fear of rising rates, are continuing to perform well. If you are invested in a well-diversified, solid-credit portfolio of muni bonds (or a good muni fund), you are collecting a significant percentage of federal tax-free income and are not experiencing the equity volatility in that part of the portfolio. And tax-exempt investors will be happy to hear that the PIMCO Total Return bond fund, absent Bill Gross, has outperformed its benchmark and most of its peers since his abrupt and dramatic departure. Again, the discipline to stick with bonds and to stick with a solid management team in spite of bad headlines has worked out well.

To be clear, markets don’t always rebound quickly, and sometimes, sticking with a strategy means a significant period of discomfort. This process is seldom quick and easy — but it works, and the alternatives don’t. Be of good cheer!


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