Sunday, June 17, 2012

The New Normal: Continued Volatility

A recent investment newsletter from PIMCO's Neel Kashkari, takes a look back at PIMCO's application of the "New Normal" comment for the global economy in the spring of 2009. "The New Normal called for long-term deleveraging that would lead to lower growth than society had been accustomed to." One outcome of this New Normal cycle has been an increase in market volatility.

A result of this heightened volatility is the fact investors have become skeptical of the equity markets. PIMCO notes:
  • "From May 2002 to May 2007, during the old normal, the S&P 500 experienced a 5% correction from a recent high five times, or on average of once per year, and a 10% correction four times."
  • "In the three New Normal years from May 2009 to May 2012, the S&P 500 experienced seven 5% corrections, more than twice as often, and a 10% correction three times."
This increased downside volatility is evidence investors should consider investment strategies that could limit the negative impact of downside market returns. Aside from sitting in cash, some of the strategies mentioned in the article include:
  • "Buying higher-quality companies and those with strong balance sheets, because they tend to be more resilient against shocks, according to our research."
  • "Buying companies at deep discounts to their intrinsic value."
  • "Buying companies offering more immediate return on investment through dividends."
  • "Actively hedging the portfolio, with tail risk hedging (which refers to taking a defensive position against extreme market shocks), or other means."
  • "Investing in multi-asset solutions that provide diversification and include equities, fixed income securities and commodities in one vehicle."
Lastly, investors and investment advisers have a choice between active and passive investment management. A potentially significant drawback of passive investment in the New Normal environment, i.e., more frequent market declines,  is investor returns will decline with the market. The S&P 500's near 40% decline in 2008 is evidence of this type of market action. For investors taking distributions from their accounts, returns like those incurred in 2008 can be more detrimental.

For investors that incorporate some downside protection in their investment strategy, this does not come without a price. Downside protection is likely to limit some of the returns achieved in an up market. However, outperforming in a down market can still result in outperformance and higher compound returns over a complete market cycle.


Three Years and Counting
By: Neel Kashkari
June 2012

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