Markets are down a healthy 10%, which from a price perspective is well within the range of what we were looking for when we started the quarter with the theme of consolidation and continuation (the bull will stay intact and rise once the correction has run its course). The question of whether the correction will be shallow or not has been answered: We’re past the shallow end. The question now turns to whether the correction will be contained to healthy levels (around current levels of decline), turn deep (stretch to around 15%), or become a bear market (once we hit 20%, it will be a bear). As we knew coming into this correction, the deeper it goes, the more it will test our investment team’s conviction level.
Generally speaking, this summer is shaping up to look a lot like the past two summers We have a market coming off complacent and stretched conditions, a European economic and systemic mess, a slowdown in economics across the globe, and the political anxiety of a fiscal cliff. We don’t like it, but that’s life in the big city.
Under our current view, we have employed a ratchet strategy to take advantage of the consolidation, and we have been slowly ratcheting down our buy-in level on the S&P, while at the same time ratcheting up our sales level on our long treasury bonds. We had said in the past that as long as our view stays intact, we might consider increasing volatility up to 5% over benchmark levels if the correction goes deep. The key phrase in all of this is “as long as our view doesn’t change.” During our last investment committee meeting, I made clear that we might change our view, and outlined the things that could lead us to that (business cycle call, uniform technical damage, system risk, a major shift in our independent analysts).
While we’re not changing our view at this time, it is facing its first big challenge. As prices move quickly, we’re left to determine whether price damage is simply blurring things temporarily (making this the buying opportunity we thought might come), or whether the facts on the ground are changing enough to warrant a shift in our current call.
Tomorrow, the investment team will meet to go through every step of our process to get to the bottom of whether or not there have been material changes. If we conclude that the evidence hasn’t shifted enough to warrant an alteration in call, then we’ll have a great chance to lock in prices at lower levels and increase our volatility in a countercyclical fashion. But if we determine that things have changed materially, then we need to decide what that means to our portfolio allocations.