Learn why diversification might not even be enough to protect your portfolio this time.
KEY TAKEAWAYS
MY HOT TAKES
Namaste. Markets are on the move… in case you missed it. The VIX Index is elevated, though not anywhere near panic-mode. No. As of this morning the VIX is at 19. A rule of thumb has levels over 20 as being noteworthy, though I use 18 as that ceiling, based on my experience. Despite this most obvious observation, we all know that the markets are volatile, and we all are probably aware of what the source of the volatility is.
We also know that there are going to be new tariffs that kick in next Tuesday, Liberation Day (coined by the President). We have also learned that there is probably more that we don’t know than what we actually know about the Administration's trade policy. A work in progress, to be benevolent. I have covered this a number of times, but I want it to be clear. The market does not like unknowns, and at the moment, we are sort of off the charts in our “unknowns” inventory.
Let’s break this down in an attempt to better understand exactly what it is that is causing so much digestive distress for investors. To help me in this explanation, I will call on two of my most trusted mentors, Harry Markowitz and William Sharpe. These two are credited with what we refer to as Modern Portfolio Theory or sometimes MPT. You may think that using the adjective “modern” is somewhat of a misnomer, given that it was described in two seminal papers written in the 50s and 60s (Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77–91. And Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3), 425–442.). The work of those papers lay the groundwork for all portfolio management today. In fact, the two, along with Merton Miller won the Nobel Prize for Economic Sciences in 1990 for their work. It must be important if I spent so much time on this introduction.
Markowitz introduced the concept of diversification, which these days, even the kid on the subway trading options on his phone enroute to work, knows about. It is drilled into every investor's psyche. When describing risk, MPT breaks it down into two distinct classes. The first is Systematic Risk, or market risk, and the second is Idiosyncratic Risk.
Let’s start with the latter. Idiosyncratic risk, or company-based risk, comes from a company’s performance. Earnings surprises, company news, etc. can move stocks, and those are generally unknown. Markowitz demonstrated how we can minimize Idiosyncratic risk through portfolio diversification. For example, if one stock has a bad earnings announcement and declines as a result, only that stock will fall, and the others will not. Though it seems obvious, having multiple stocks in your portfolio minimizes overall risk. Interestingly, Elton and Gruber (Elton, Edwin J., and Martin J. Gruber. (1977). Risk Reduction and Portfolio Size: An Analytical Solution. The Journal of Business, Vol. 50, No. 4 (Oct., 1977), pp. 415–437.) showed that owning even 20 random stocks, equally weighted, that an investor can eliminate around 80% to 90% of idiosyncratic risk. Keep that thought, we will be back to it in a moment… or two.
Moving on to systematic, or market risk. Let me go to my trusty rusty book of Wall Street Sayings. Here it is on a well-worn page: “A rising tide lifts all boats.” Implied in this is that all boats go down in the ebb tide. This can be expanded even further by saying that even if you buy fewer volatile stocks, they will still behave more erratically in a volatile market. This concept is implied in Markowitz’s MPT. You cannot eliminate market risk through diversification. It is the bane of all portfolio managers. No matter how much homework they do, no matter how good the portfolio components, if the market is misbehaving, so will their portfolio.
So, let’s back up and talk about the markets lately. They are clearly volatile due to political uncertainty. As stated above, the massive, and growing number of unknowns coming from DC. To be clear I am not just referring to the President, the Fed too has done a good job at keeping markets in the dark. That leaves all indexes in price discovery. Will tariffs affect companies? Which ones? By how much? Will they affect consumers, which ultimately affect earning? Which ones and by how much? Lots and lots of unknowns have sent indexes on a bumpy path with what feels like a negative bent.
In the MPT framework, we have high Systematic Risk, which, if you have been paying attention, cannot be avoided by simply owning lots of stocks. Additionally, we are all left wondering about the stocks that we own. What affects will tariffs and the prospect of trade wars have on their earnings? Regardless of tariffs, can the companies continue to grow at the same rapid pace as the past few quarters? Will consumers start buying less if the economy falters, affecting revenues? Will inflation pick up again causing consumers to put off purchases?
Some of the questions regarding companies will be answered in earnings season, which starts soon. They are not likely to be answered in the numbers themselves, as they will be announcing Q1 results, principally prior to tariffs, but we will learn a lot in forward guidance and management commentary.
Let’s take Lululemon, which announced its Q4 results last night. It beat EPS and Revenue estimates by 5.05% and 1.06% respectively, and yet the stock is down by some -12% in the premarket. Why? Because the company gave full-year and current-quarter guidance that was softer than expected. If you listened to the earnings call or read the transcript, you would note that the company expects headwinds from tariffs in 2025. “We’ve got approximately 20 basis points of a headwind embedded in our guidance, which is reflective of current actions on China and Mexico imports” – according to CFO Meghan Frank. Further, Frank commented “At the highest level, I just call out FX and tariff headwinds are a little bit over 50% of that decline in op margin,” when referring to guidance. And one final quote on the consumer
“We also believe the dynamic macro environment has contributed to a more cautious consumer. In fact, based on a survey we conducted earlier this month in conjunction with Ipsos, consumers are spending less due to increased concerns about inflation and the economy.”
Ipsos, by the way, is a third-party market research company. We have recent data from sentiment indicators that corroborate this assumption, and this morning we will learn about Personal Spending last month. Spending had a surprise decline in January, and it is expected to have rebounded by 0.5% last month. We will also get a final read of University of Michigan Consumer Sentiment this morning. Its early-month reading showed a decline–let’s see if it gets revised today.
What does this all mean? Markets, which we can’t control are causing a bit of havoc to our portfolio. Within our portfolio, even if we are diversified, the companies all have the likelihood of reporting similar impacts from the same macro headwinds that now vex the markets. So, high Systematic Risk and high Idiosyncratic risk. Diversification can help, but every stock you own is encountering the same challenges. That is a description of the way things are, folks. The prescription? Stay focused on the long run and maybe start with a DEEEEP cleansing breath. Namaste.
YESTERDAY’S MARKETS
Stocks swung violently between green and red, ultimately choosing red, as investors digested the uglier than expected auto tariff announcement from the night before. Longer Treasury yields gained marginally in the session adding to the pain. All eyes are on this morning’s inflation figures with hopes that the Fed can become a friend… again.
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