Navigating Markets: Using Volatility and Buy Lists

By Aline Wealth Management on March 5, 2018

In the last couple of weeks we have seen a resurgence in volatility, a measure that had been absent for all of 2017. Increased volatility can be a useful environment for investors who are more actively managing their portfolios rather than those passively managed through index funds (which would simply mimic the broad market’s decline). Of course, actively managed portfolios are far from a panacea in an increasingly volatile market backdrop but what an actively managed portfolio does provide is the ability to allocate previously kept-on-the-sidelines cash capital at now lower levels. This exercise is the definition of tactical allocation – maintaining cash (“dry powder”) while conditions are somewhat ebullient and valuations are stretched only to then, strategically and efficiently, deploy when prices fall. Tactical allocation is less about market timing and more about “value timing”—valuing investments and waiting for the opportunity to buy them at attractive prices.

This notion of price vs. value is one that warrants attention by all investors. Price is a function of supply and demand, the more demand the higher the price and vice versa. So you can just imagine how proverbial “bubbles” are formed—buyers beget higher prices which bring in more buyers and the cycle continues to build irrespective of value. Value on the other hand is a construct of fundamental analysis—using the tenets of finance and basic business sense, an investor forecasts the value of a security or business. The premise that underpins much of this process is the discounting to present value the future cash flows generated by an investment—of course assumptions (discount rate, growth rate, cash flows) need to be made as a crucial part of this exercise and as such will ultimately determine the underlying value.

Markets, due to their nature, rarely present an equalization of price and value—either one is too high or too low and it is the function of the mindful investor to recognize and to exploit such inefficiencies. So when prices are too high, as they had been for much of 2017, investors might be well served to develop a “buy list” based on their estimation of value and wait for the market to provide an opening to carefully, but often opportunistically, deploy a portion of their cash reserves. It should be noted that this is not an “all-in” or “all-out” exercise. Investing works most efficiently as a combination of the passive and active styles (also known as “Core-Satellite”), so while we may be seeking opportunities to allocate cash to undervalued investments we should still maintain a passively allocated portfolio for a portion of the portfolio.

Determining when to dial back exposure and when to increase it (allocate cash capital to investments; that is, going from a no risk asset to risk assets) investors should spend a considerable amount of time valuing the overall market conditions—the valuation stats, the growth expectations, the quality of earnings and the macroeconomic underpinnings—as well as an assessment of the current market sentiment (how investors are behaving—complacent/fearless or concerned/fearful). By the way, when it comes to sentiment, investors are typically well-rewarded (over the long term not over the short term) to go against the herd, that is, to adopt a contrarian strategy—if everyone is bullish and fearless better to adopt a more defensive strategy and vice versa when investors are frightened and running for the exits.

A Primer on Technical Analysis and Market Corrections:

Technical analysis (the study of chart patterns) provide signals about investor psychology, which in our view, is what ‘drives’ markets over the short term.  In addition to investor psychology, technical analysis is also firmly ensconced in the element of supply and demand—the actual supply and dynamics of a specific security at a specific price. Is there support at a specific price level could be deciphered as to mean: are there investors who purchased the shares at level in the past and if so they may look to buy more there—hence “support”. The opposite notion defines the element of “resistance”—a price where a security may have difficulty going higher. Even those unfamiliar with technical analysis can see the simple patterns – corrections typically start with a sharp decline, a ‘bounce’ and then the S&P 500 either makes a new low over the coming months, or at the very least, ‘tests’ the low by trading down towards the low. Let’s dig deeper into each “move”:

  • Initial low:  Markets go through a ‘shock and awe’ scenario where prices decline rapidly.
  • Bounce: Investors see prices 5-10% cheaper than a few days or few weeks ago, begin to buy because there is a “sale”.
  • New low/testing the low:  Prices decline rapidly, usually resulting in an environment where selling is exhausted – everyone who wants to get out sells. There are two causes of the secondary low/testing the low:
  1. Investors that see the correction as the start to a bear market and upon prices rising, take the opportunity to “get out” and sell into the temporary strength.
  2. Market volatility does not subside quickly in markets (it lingers!) and the elevated levels of volatility create anxiety, which typically results in a declining market.
  • Ultimate low: Long-term and objective investors conclude that the correction is not a bear market, but simply a market event and over time, the market will recover. Buying ensues, but due to the selling exhaustion mentioned previously, the buyers are more urgent than the sellers, so prices rise quickly. Optimism breeds more optimism, and eventually, prices continue to rise in a self-reinforcing loop.

So – where are we now?  In our view, the recent recovery from the recent nadir may not represent the final low. That intraday low did not produce the exhaustive selling spike that is consistent with an ultimate low and if that was indeed the low it would represent the shortest correction in over 50 years.  We see more sideways trading and potential for continued volatility in the near term which could be an excellent opportunity for the investor who has a well-researched buy list and the capital at the ready to put to work. Stay patient (and opportunistic) my friends!

Source for all data: Bloomberg


Aline Wealth Management is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC (member FINRA and SIPC). Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

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