As we created our brackets in time for NCAA March Madness, pruned the vineyard and cleaned up our yards after the big windstorm, it was time for our quarterly investment committee meeting. 

A sideways moving market, as we have seen recently, requires a different mindset to navigate. Indeed global developed markets have been flat for a couple years now, emerging markets have been flat for 10 years, and US Small Cap stocks have had zero return since late 2013. Most Wall Street sources have described it as, “The most hated bull market ever.” The following charts have us asking ourselves, is it possible the bull market ended and no one noticed yet?

With major stock market averages in the midst of a pullback, I thought it would be interesting to review the risks we have seen in the markets. As of this writing the S&P 500 dropped below its 200 day moving average for the first time in 477 days (third longest streak in history). Small cap stocks have been especially susceptible (down 13%+ on a price basis since end of June). This pullback is no coincidence, the stock markets domestically and internationally have benefitted from the global experiment of Quantitative Easing. Indeed the correlation of increasing stock prices in the midst of each round of quantitative easing is unmistakable. Likewise, the subsequent fall of stock prices, as each round has ended is distinct. Therefore, with the end of QE3+ on the horizon, there is no wonder that stock prices are under pressure.

As recently as 10 million years ago, the Amazon river actually flowed east to west. At the base of the northern Andes, it formed a large lake that eventually flowed into the Caribbean Sea. Over time, it reversed course as the continent tilted and sediment built up. If the largest river on the planet can change directions - couldn’t the stock market?

“The less prudence with which others conduct their affairs, the more prudence we must use in conducting our own.”

 

-- Howard Marks’ favorite quote

As a portfolio manager, I have two jobs: 1) Define the playing field by understanding risk and 2) Once the playing field is defined, invest in opportunities that offer our clients the best risk adjusted return in order to achieve their goals. Last quarter we discussed our probabilistic approach in defining the playing field and understanding the dynamic of the risk/return tradeoff. This quarter I will update you on our thoughts on risk and share some thoughts on portfolio construction in light of these risks and uncertainty.

The double digit stock market returns we experienced in the first quarter should give us a reason to pause. Being 48 months removed from the financial crisis, we feel investors have developed unrealistic expectations for future returns, which will ultimately lead to disappointment. Given the prospects for future gains, we should expect that dividends will make up more than 50% of domestic stock market returns over the next 10 years. Meanwhile, bonds are underappreciated by investors. This is due to the expectation of rising interest rates. In our view, investors have forgotten the benefits of the liquidity and diversification that bonds offer. Lastly, as has occurred in Cyprus recently, when small and largely inconsequential events occur to the detriment of a few, it should serve as a sober reminder of the risks we regularly face as investors, especially when risks are largely ignored.