The MPZ Group at Morgan Stanley Newsletter

Transcription

1 The MPZ Group at Morgan Stanley Newsletter Dow Milestones and Other Potential Senseless Acts of Courage 1001 Days of a Thanksgiving Turkey A Parable for Risk Management For our letter this quarter we d like to focus on Nassim Taleb s analogy of the life of a Thanksgiving Turkey and the dangers of empirical assumptions and the inherent pitfalls many of us face when assessing risk and managing investment portfolios. In his book, The Black Swan, The Impact of the Highly Improbable, Taleb describes the life of said turkey, which goes like this: For as long as the turkey can recall his friend, the farmer, came to feed him and care for him. Each day the farmer arrived, the turkey expected to be fed. Each day that the farmer fed him, the turkey received confirmation of the farmer s love for him. The turkey s certainty grew and grew with each day that passed. All appeared normal until that fateful day, before Thanksgiving, when the farmer arrived baring an axe rather than corn feed. The chart below replicates the event from the perspective of the unsuspecting turkey. All looks to be going well until it s not. Source: The Black Swan by Nassim Taleb

2 The analogy serves as a powerful reminder that no matter what is currently transpiring in the market, we must be ever vigilant of the prospect of getting our heads cut off. We must remember that the stock market, at its core, is essentially an aggregation of human emotions. While analysts will breakdown valuations and serve up predictions based upon this analysis; ultimately the market follows these two human emotions fear and greed. The chart of the turkey illustrates that the turkey s confidence is at its highest at the top. He has received repeated confirmation that he is right in his assumption about the farmer, and he can only foresee future positive outcomes. The Stock Market and The Turkey s Life The stock market has also previously followed the path of the Thanksgiving Turkey. The next chart shows the most recent example of Turkey Living. This chart highlights the period from 2003 to 2008 for the S&P 500. Enthusiasm for stocks appeared to be at its zenith in October of 2007, price movement at that moment appeared to illustrate a market environment in which the expectation for future returns was higher than it has ever been in the last 5 years. Investors appear eagerly anticipating the next day s feeding from their caretaker. However, at that moment the axe is about to fall. No prior empirical evidence, over the last 5 years existed to indicate that the end was nigh. Yet one day sentiment changed and within 12 months the market lost half its value. The chart also clearly illustrates one of my favorite market sayings, The stock market takes the escalator up and the elevator down. Source: Thomson ONE So what does this mean for you and your investments? It means that for the core of your investment portfolio you should seek a more balanced strategy. If you cannot stomach or afford a 50% decline in net asset value then you shouldn t concentrate your investments within a single asset class. Risk balance equals prudence. However, for the portion of your portfolio that you would like to allocate to growth, seek investments with asymmetric returns. Finding investments that are asymmetric investments that offer potential returns that are significant multiples to the capital at risk are unique and challenging to find, but we can help you identify them and put them in place. We believe balancing risk and opportunity can help you capitalize during bull markets without giving up the farm in bear markets. We all hate the idea of not profiting when times appear good. Fear of missing out is a powerful emotion, however selecting these asymmetric returns can keep you from ending up like a turkey.

3 A Recap of Previous Milestones for the Dow Jones Industrial Average Dow 100 Dow first crossed in September 1916 By December 1917 the Dow made a closing low of 65.95, 36% lower than the milestone level Dow last traded 100 in June of 1942 milestone level: Dow 200 First crossed in December 1927 On September, the Dow closed at , over 90% higher than the milestone. By July 1932 the Dow traded 41.22, nearly 90% lower than its all-time high and almost 80% below the 200 milestone. Dow last traded 200 in January 1950 milestone level: 265 Dow 500 First crossed in April 1956 Dow regains 500 for good in July 1958 milestone level: 26 Dow 1000 First crossed in November 1972 On October, Dow closed at , nearly 42% below milestone level. Dow finally regained 1000 for good in December 1982 milestone level: 121 Dow 5000 First crossed in November 1995 By April 2000 Dow traded 11,287, an astonishing 125% above milestone level. Dow never touched 5000 again, although it comes close within 600 points in March 2009 price level: 0 On December 20, 1957 Dow closed at 427.2, 14.5% lower than milestone price. 1 All Dow Jones Industrial Average Price data received from measuringworth.com

4 Dow 10,000 First crossed in April 1999 By April 2000 Dow rallied an additional 11.3% to 11,287 before falling below 10,000 in August 2001 By October 2002 the Dow made a low of 7200, 28% below milestone price. Dow finally regained 10k for good in July 2010 price level: 135 Dow 15,000 First crossed in May 2013 Has risen 33% since milestone Hasn t touched 15k since October 2013 price level: 4 Dow 20,000???? What to Make of This Significant Milestone? As the Dow approaches 20,000 euphoria has begun to enter the market. Will this milestone presage the final thrust higher for this bull market run like Dow 10,000? Will it become a market top that we fail to penetrate for 10 to 15 years in the future, like Dow 1000? Or do we cut through it like a hot knife through butter as we did with Dow 5000? The truth is that these barriers, while seemingly arbitrary, do seem to have a psychological effect on the market. However, the data from the past does not seem to provide us with any definitive outlook for the future. What we do know is that the further away we are from the last bear market the closer we are to the next. The bell does not ring at the top. The negative events that have accompanied these milestones in the past are not acceptable outcomes for most investors, therefore we advise not to get caught up in the euphoria. If you wish to participate in the possibility of a bull market ramp up we recommend seeking investments with fixed risk and high reward potential. The market risk, at these levels, appears asymmetric; meaning that you may be chasing a 10% reward with the possibility of a 35% downside risk. For this type of risk/return outlook we advise adjusting how you seek growth. It is impossible to know the final outcome. Buy and hold just means riding it up and riding it down. If you invest with a timeline in mind and a small, limited exposure then you would be well positioned for the possibility of a dramatic leg higher without being slaughtered if the inverse occurs. Markets are a battle between fear and greed. These symbolic price barriers are mile markers along the roadside of Greed. Their existence tells us that we are closer to the end of the road rather than the beginning. Optimal buying opportunity resides on the roadside of Fear. Unfortunately many people reverse these road signs and consequently become greedy when all appears great and fearful when all appears hopeless. Buying after periods of significant carnage is how the pigs get fat. Chasing markets when everyone is bullish is how the hogs get slaughtered.

5 The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Wealth Management or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not fiduciaries (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise provided in writing by Morgan Stanley. Individuals are encouraged to consult their tax and legal advisors (a) before establishing a retirement plan or account, and (b) regarding any potential tax, ERISA and related consequences of any investments made under such plan or account. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Wealth Management recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Foreign currencies may have significant price movements, even within the same day, and any currency held in an account may lose value against other currencies. Foreign currency exchanges depend on the relative values of two different currencies and are therefore subject to the risk of fluctuations caused by a variety of economic and political factors in each of the two relevant countries, as well as global pressures. These risks include national debt levels, trade deficits and balance of payments, domestic and foreign interest rates and inflation, global, regional or national political and economic events, monetary policies of governments and possible government intervention in the currency markets, or other markets.

6 Dow Jones Industrial Average is a price-weighted index of the 30 blue-chip stocks and serves as a measure of the U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods. An investment cannot be made directly in a market index. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index. Morgan Stanley Smith Barney LLC. Member SIPC. CRC /17