August 21, 2017
We know that many of you have been interested in the events unfolding between President Trump and North Korean Leader Kim Jong-un. Keep in mind that:
Rhetoric does not necessarily equal action: No doubt there has been much bluster in the media lately between President Trump and North Korea’s Leader, Kim Jong-un. We should keep in mind, however, that rhetoric is not the same as action. Rest assured that military policy decisions are not being based on President Trump’s tweets or Kim Jong-un’s statements. President Trump is surrounded by a strong cabinet of highly accomplished and highly experienced military leaders including Gen. James Mattis, Gen. John Kelly, and Lt. Gen. H.R. McMaster. We should trust these leaders to guide our Nation through times of crisis.
Market performance in times of conflict: History provides relevant context with respect to market performance in times of conflict. Since 1900, there have been 7 major geopolitical crises that have included armed conflict (WWI, WWII, Korean War, Vietnam War, First Gulf War, September 11th, Second Gulf War). Market performance during these periods can be described as mixed at best. In fact, markets rose more during periods of conflict than they fell. For example, from the start of WWI in 1914 through its conclusion in 1918, the Dow was up more than 40% or close to 9% annualized. From the start of WWII in 1939 through its end in late 1945, the Dow was up 50% or more than 7% per year.
We’ve been here before: Perhaps the most relevant historical context to consider vis-à-vis North Korea is how the stock market performed during the Cuban Missile Crisis when the world was on the brink of nuclear war. The confrontation between the U.S. and the U.S.S.R. lasted for 13 days from October 16th to October 28th, 1962. Surprisingly, during this tense period, the stock market was actually very calm. In fact, the Dow was down only 1.2% during the period and finished 1962 up nearly 10% overall.
Markets don’t exist in a vacuum: While it’s easy to do from a cognitive perspective, we really shouldn’t try to ascribe one situation’s direct impact on financial markets. In reality, there are nearly infinite factors impacting markets at any given time. The market’s reaction to a given set of circumstances includes how the market has performed leading up to the event--has performance been strong or weak and will a particular event propel a recent trend or reverse it. Also important to keep in mind are the potential responses from policy makers to a given event, such as the Federal Reserve’s Quantitative Easing program during the financial crisis which is widely interpreted to have helped stabilize markets and launch the subsequent rally. While it may seem easy to equate times of conflict with poor market performance, as stated, this has not historically been the case.
Low vol regime: Leading into the war-of-words between President Trump and Kim Jong-un, equity markets have been unusually quiet. In fact, the VIX, generally thought as a good measure of fear in the market, hit a historic low of 8.84 on July 26th. Further, between July 19th and August 8th the S&P 500 experienced a 13-day stretch where it moved less than 0.30% in either direction, which has never happened before dating back to 1927. What does this mean – we should expect volatility to increase going forward? Again, we can’t be sure if the situation involving North Korea will be the catalyst to sustained higher volatility, but we fully expect volatility to rise from these historically low levels as it did when the VIX rose 44% on Thursday, August 10th.
Battle-tested portfolios: When we build portfolios, our analysts use a proprietary process that includes simulating environments where markets are down sharply. We perform over 50,000 simulations including each asset class’s absolute performance as well as its performance relative to every other asset class we include in portfolios. We simulate everything from a ‘normal’ environment to ‘very good’ and ‘very bad’ environments. This process helps us right-size allocations to riskier asset classes appropriately. As a result, we never ‘bet-the-farm’ on any one asset class; and resulting portfolios are broadly diversified among 10 – 15 distinct asset classes which tend to reduce overall volatility and hold-up better when any one asset class is experiencing a period of stress.
Bonds as ballast: Should some portfolios still contain bonds? The Fed has embarked on a monetary policy-tightening campaign by raising its short-term benchmark Fed Funds interest rate beginning late last year. Our shift into more foreign and emerging market bonds while fine tuning our domestic bond holdings has worked out very well. Recent events are a perfect example of why we maintain dedicated allocations to fixed income and other diversifying asset classes, such as commodities, through all environments. This is because we can never be sure when a geopolitical crisis is going to flare-up. Bonds tend to act as a ballast in diversified portfolios, holding-up better when riskier asset classes become more volatile. Energy, and oil and natural gas specifically, are strategically important commodities and tend to increase in price when geopolitical events threaten supply, which tend to coincide with a market downturn. If we can reduce volatility at the overall level, portfolios have to recover less following these inevitable market downturns, which should enhance longer-term returns.
We have a plan: Using our analysts' proprietary asset allocation application, we design portfolios we believe give us the highest probability of achieving long-term return targets with the least amount of risk possible. While it’s easy to focus on the performance of one particular asset class or market, particularly those markets quoted in the financial press and news media on a daily basis, what’s more important is how portfolios are performing relative to stated investment objectives over time. In other words, we need to focus more on the investment objectives we are trying to achieve as opposed to what the S&P 500 is doing on a day-to-day basis. Sticking to the plan and avoiding emotional reactions to headlines and day-to-day market gyrations remains an investment strategy.
As we always say at Lineweaver Financial Group, one size does not fit all. You and your family likely have unique concerns based on your specific situation. If you’re wondering how well prepared you and your family are, we offer a no-obligation analysis, to help give you peace of mind. To schedule time with an advisor, you can call us at 216.520.1711, email us at quarterback@Lineweaver.net, or click here.