The Waiting Game
- The economic and interest rate cycle is not at a tipping point
- Investors should consider the interaction of volatility, holding period, taxes, and valuation
- Avoid turning volatility of stock prices into a realized loss
Despite a lot of financial press expressing concerns about the duration of the current expansion and stating that now might be a time to consider selling securities (while stocks and bonds are at record high prices), we have a different assessment. Equity bull markets historically end when three circumstances are present: economic expansion is within sight of ending, valuations are high, and interest rates begin choking consumers and businesses. Today, each of these conditions is present to varying degrees, but in our view none are at a trigger point.
The chart on the next page shows 10 key economic drivers of the U.S. economy, about half of which are in a positive trend, and the other half in a fading trend. Since the balance of indicators is generally okay, we feel there is more time ahead for the economic expansion. However, the majority of these components will eventually cycle downward, causing the expansion to come to an end. In anticipation of that downward cycle, equity prices typically begin their own cyclical downturn. Determining when the economic cycle will turn is very hard to predict with useful reliability, and predicting when equity prices will decline is nearly futile. Yet many hold on to the view that such predictions are possible. We instead believe that long-term investing principles should apply during such negatively volatile periods.
So what is an investor to do? This is where understanding the interaction of volatility, holding period, taxes, and valuation can help determine the right course of action.
We like to think of volatility as temporary and loss as permanent. Historically, to minimize the risk of loss, investors must hold their ownership in a security for two times the average economic and stock market cycle (approximately five to eight years). If you expect to sell out of equities before two times the length of an economic cycle, or during downward volatile periods, then it’s best not to invest in equities. One of the mistakes that equity investors make is turning volatility into a loss. How does one do that? Typically this happens when an investor owns a really solid company at a fair valuation but they can no longer emotionally bear the decline. As a result, they sell the stock despite experiencing downward volatility.
On the flip side, when you hold your high-quality stocks and bonds for two times the length of the average economic cycle (and particularly during downward volatile periods), you are much more likely to achieve your long-term investment objectives. Selling good companies during downturns is almost always a sure way not to reach long-term investment goals. The answer to how far and for how long the downward volatility will take a company’s stock is influenced by the level of valuation of the stock and the depth of the downturn in the economic sector in which the company operates.
Taxes are also an important factor, because selling a stock in advance of such a downward period of volatility means paying 20-25% of your gain in taxes. That cost need not be borne if you hold for the long term. Before investing, understand the amount of downside volatility and your emotional commitment to seeing your equity value decline for a temporary period (sometimes temporary means a few years). Then, understand what selling a stock actually costs an investor in taxes, and commit to owning quality companies at fair valuations. Valuations affect downward volatility when they are too high (which ends up increasing the downside volatility), and they increase the time it takes the stock price to recover. Valuations do matter over the longer term; therefore, we do not believe in owning companies at premium valuations.
Where are equity valuations and bond valuations at present? We consider both equity and fixed income valuations as full and in the “yellow zone,” indicating a degree of caution.
So, why not sell? There are three reasons:
- Valuation can remain in the yellow zone for years.
- Valuations alone do not determine when a stock will decline.
- We believe the economic and interest rate cycle is not near a faltering point.
City National Rochdale will begin to prudently lower its exposure to stocks and/or bonds when we believe the faltering of the economic expansion has come into sight, and/or if valuations enter the red zone of overvaluation and therefore the risk of loss is too high over an extended investment period.
Non-deposit Investment Products:
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice.
Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
Any options, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
All investing is subject to risk, including the possible loss of the money you invest. When interest rates rise, bond prices fall.
Past performance is no guarantee of future performance.
This material is available to advisory and sub-advised clients of City National Rochdale, LLC, a Registered Investment Advisor and a wholly owned subsidiary of City National Bank.