Volatility can lead to opportunity

Back in January, one of the themes that we talked about at Morgan Stanley was to expect volatility to pick up in 2014. Historically, when the Fed has reversed course and begun tightening monetary policy, it’s been coincident with a pickup in volatility of the equity markets.

As we know, the Fed has been reducing monthly bond purchases by roughly $10 billion each month, and, in effect, that’s a form of tightening. So we’re not too surprised to see volatility picking up a bit.

So while volatility is normal at this point in a recovery, it doesn’t mean that the recovery is over. We think investors really ought to look at this as an opportunity to put some cash to work and use some of these breaks in the market to increase positions or add to positions.

The mid-January and early February market corrected about five or six percent, and within a short period of time, the markets were back in the black, so a lot of people were caught flat-footed. It happened quite fast, so we’re taking this opportunity to go back and point it out as a cautionary note to tell people to be ready if there is an opportunity to step up.

Alternatives and the Bond Market

Last year the real outlier in the markets was U.S. stocks – far and away the winner. If you look at some of the other asset classes, they were on the negative side. This year it’s been a bit of a move toward the opposite. Many of the asset classes in the alternative category are having really solid returns this year. For example, gold and real estate investment trusts (REITs) are up.

With the bond market, one of the things that we believe is occurring is that a lot of large, institutional investors – pension funds, for example – have an asset allocation strategy that they need to stick to. With stocks being up 30 percent last year and bonds being down a few points, they need to rebalance those portfolios and get them back to their longer, strategic kind of asset allocation, and that involves selling stocks and buying bonds to meet their asset allocation constraints.

So we think that’s something that’s going to play out here in the near future, and that rebalancing will probably be complete sometime sooner rather than later. This will probably take a little bit of the punch out of the bond market right now.

How to deal with market volatility

Don’t abandon the long, successful principles of asset allocation. Let’s take a moderate risk investor today who is equally concerned about growth and safety. We’re typically going to advise having stocks in that portfolio somewhere around 50 percent.

Bonds are going to be somewhere around 20 to 30 percent. Cash is going to be something less than 5 percent, and then alternatives would be somewhere around 20 percent. That’s what a typical allocation would look like. You could go a little bit on either side of that, depending on if you are more aggressive or more conservative.


Categories: Finance