At its closing low last Tuesday, the S&P 500 Index was 12.5% below its all-time high of 2,135 and well into what market observers consider to be ‘correction’ territory. Intra-day lows early Monday were even scarier, in an apparent wave of indiscriminate selling. Given the speed of the decline (10%+ in six trading days), the spike in volatility (the VIX index shooting to 50 from 15 just a month earlier), and the rampant speculation about China dragging the global economy into a recession, it is fair to ask whether this is the start of a bear market decline or simply a healthy correction. While we believe the probability of a bear market is low, this question presents a good opportunity to explain how HM Payson views market volatility within the context of the portfolio management process.

There are two components to portfolio management: 1) bottom-up security selection – our bread and butter, and something we pursue in any market environment; and 2) asset allocation, which is the process of managing risk exposures across asset classes (stocks, bonds and cash). We will address security selection later but, given our long-standing bias toward equities, a look at the asset allocation process is timely.

The Market Mosaic

Our asset allocation framework is influenced primarily by our valuation-based “expected returns” work for all asset classes. As an overlay to this, we utilize a mosaic approach taking into account Economic Conditions, Monetary Conditions, Market Technicals and Market Valuation. This framework is designed to avoid large-scale bear market declines while keeping our clients invested for the more relevant long-term goal of purchasing power protection. As we outline below, we believe this framework currently points to a favorable environment for equities. Moreover, for active managers like us, the recent volatility has presented a number of attractive buying opportunities.

Economic Conditions – While the global economy is struggling somewhat due to weakness in Emerging Markets, the most important factor for equity markets is the health of the United States economy. On this front, the outlook is highly favorable as evidenced by a number of indicators. Among them, one of the most effective has historically been Initial Jobless Claims. The United States has never entered a recession without the 4-week moving average of Initial Jobless Claims rising by 20% year-over-year. At present, this indicator is falling by 10% year-over-year. For now, we rate Economic Conditions as favorable.

Monetary Conditions – With record low interest rates, exceedingly friendly corporate and consumer credit conditions and the safest banking system in decades, the Monetary Conditions component of our framework is highly favorable at this juncture. Even with a modest (and highly anticipated) increase in rates from the Fed, conditions will remain very favorable by historic standards. Due to its leading tendencies, a favorable monetary environment helps to confirm the favorable economic conditions we believe are currently in place.

Market Technicals – Though not well understood and relatively opaque, Market Technicals gauge market pricing action and a number of sentiment indicators. For longer-term investors, a relevant market signal is the 200-day moving average, which simply indicates whether the market is in a long-term uptrend or downtrend. This is a slow-moving indicator that will not catch the top or bottom of a market but can be useful in confirming a positive trend or signaling a more substantial decline. At present, both the All Country World Index and S&P 500 200-day moving averages are rising, which we view as favorable. As an aside, sentiment indicators, showing extreme pessimism, were also favorable last week. Though this may be counter-intuitive, think of it this way: bear markets are almost always preceded by excessive optimism. With pessimism high, risk is usually low.

Market Valuation – Primarily due to extraordinarily accommodative monetary policy and record high corporate profit margins, global and U.S. equity markets are trading at elevated valuations. Since experience has shown that elevated valuations usually portend below-average returns, our projected returns for equities are modest. We rate this configuration as unfavorable.

As has been the case for some time, despite the potential “valuation headwind” for stocks, other asset classes (bonds, cash) offer no real (inflation-adjusted) return at all. Therefore, in our view, the weight of the evidence points to a favorable environment for equities.

Portfolio Implications

The recent volatility has been unsettling, to say the least. We also should caution that the initial rebound does not guarantee that the worst is over in the short run. However, in the context of a six year bull market that has not experienced a meaningful correction since 2011, a healthy retrenchment should not come as a shock. Given the favorable conditions outlined above, we believe the market is unlikely to enter into a true bear market decline – but if the declines do continue, they will likely be limited to a typical non-recessionary bear market average (approximately 20%). While painful in the short run, non-recessionary bear markets are manageable for investors with 3- to 5-year time horizons and typically present wonderful buying opportunities… which brings us to the bottom-up perspective.

Warren Buffett regularly reminds his followers that a stock’s price is rarely an accurate reflection of the underlying company’s intrinsic value. In the short run, the price can be much higher – or lower – than the present value of the future cash flows that will benefit investors in the form of growth, dividends, or stock buybacks. For price sensitive “bottom-up” investors, periods of volatility can present excellent opportunities, as price insensitive sellers disgorge shares in a knee-jerk reaction to ominous sounding headlines. For many months now, the prices of many high quality, dividend paying stocks have been lagging crowd favorites like Amazon, Facebook and Netflix. As such, valuations for many of our favorites were already quite reasonable; last week’s decline only made them more so.

As we mentioned earlier, the relevant risk to most of our clients is the potential erosion of purchasing power to inflation over time – NOT short term volatility. Volatility, of course, can lead to a permanent impairment of capital when judgment is clouded by fear or greed, causing poorly timed decisions to exit or enter the market, but with an experienced advisor and a well-reasoned investment process in place, volatility can be a long-term investor’s friend.

As always, we encourage you to call us with any questions.

This commentary is prepared by H.M. Payson for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of any security. The information contained herein is neither investment advice nor a legal opinion. The views expressed are those of H.M. Payson as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes. H.M. Payson cannot assure that the type of investments discussed herein will outperform any other investment strategy in the future, nor can it guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. Although information has been obtained from and is based upon sources H.M. Payson believes to be reliable, we do not guarantee its accuracy. There are no assurances that any predicted results will actually occur. Past performance is no guarantee of future results. Registration with the SEC or with any state securities authority does not imply a certain level of skill or training.