Market volatility: September 12, 2012


To GK Capital Partners investors and friends,

Recent volatility in equity markets is causing a lot of understandable stress. I just wanted to connect over email quickly to assure you that I am watching events closely and monitoring the effects on the portfolio. It’s unfortunate that we have to go through this pain, but I remain very comfortable with the way the portfolio model is allocated.

Something to keep in mind is that there is a massive amount of capital in the markets that has a very short-term investment horizon. Most hedge funds, for example, either optimize around or pay very close attention to their monthly performance numbers–and traditional long-only mutual fund managers care quite a bit about quarterly results. And the media behave as if their time horizon is even shorter than that and select their “expert” commentators accordingly. This has resulted in a dramatic increase over the years in the volatility of investor sentiment/confidence, which causes wild short-term market swings.

We, on the other hand, all have long-term savings and investment agendas and need to find ways to screen out the short-term noise to focus on what’s important to us. So, first of all, the reason our model portfolio only allocates 35% to equities is that I (we) want this to be a defensive and low-volatility asset accumulation process for us all. Typical long-term models allocate 60-80% to equities, and if you do the fancy math, that actually means that about 95% of the “risk” in the portfolio is driven by stock market movement. That’s dangerous because it increases short-term volatility which increases the likelihood that an investor will bail on their investment/savings program.

Second, valuation levels right now are attractive relative to long-run averages. Many large US based companies, often with multinational business platforms, are trading at 10-13 times earnings (historical average is about 16-18) and pay dividend yields twice that of the current 10-year US Treasury yield (and have loads of cash on their balance sheets). Historically this type of valuation level has been a very good entry point for equity investing. Now, earnings multiples can go down further and earnings estimates can be lowered, so I’m not trying to call a bottom, but right now the upside is definitely much larger than the downside and I believe we will be paid appropriately over the long-run for staying invested.

Third, the other 65% of the portfolio is allocated to bonds, absolute return strategies, REITs, natural resources and commodities. This is a very diverse basket of investments that don’t move in tandem with the stock market (clearly the natural resources and commodities respond similarly to stocks with regard to general economic outlook, but they also provide the portfolio a substantial hedge against inflation). THIS is the “core” of our portfolio.

I have attached a short research report I received discussing recent volatility in case you want to do some more reading. Some of the managers have interesting comments. I completely agree with the following comment from Zevenbergen Capital:

…the markets have been trying to determine the extent that recent events (European debt burdens, U.S. credit rating downgrade, Japanese earthquake, etc.) will contribute to economic weakness, possibly a recession. We have experienced these tumultuous market environments several times in the history of our firm and can attest that it has never been rewarding over the long-term to make judgments or portfolio changes when emotions such as fear and panic are guiding many investors.

I commit to you that our investment decisions will be driven by the deep beliefs and understandings I have with regard to the fundamentals of capital markets and not on emotions. I take the responsibility of managing your money very seriously.

Please feel free to contact me anytime to discuss.