At the conclusion of last quarter’s newsletter we left you with the statement, “At some point we will experience greater market volatility than we had the benefit of avoiding in 2017.” Unfortunately, the statement rang true sooner rather than later as the S&P 500 gave away all of January’s gain in early February. However, as you have heard us discuss many times in the past and exists as one of the core tenants of our investment philosophy and strategy, volatility remains our friend and a source of great opportunity!

Graph 1 illustrates one commonly referred to measure of volatility – the Chicago Board of Options Exchange SPX Volatility Index or the VIX. We will not delve into the technical details of how to calculate the value of the VIX. However, it represents the stock market’s expectation of volatility implied by S&P 500 index options. An increase in the value of the VIX represents an increase in volatility of the S&P 500. One can see below that the VIX spiked in early February 2018 during a period in time when the S&P 500 gave back all of the 5% return from January 2018. Similarly, from the five year graph, one can see that the last bout of increased volatility in the S&P 500 came around the end of 2015 and early 2016, a period of market decline that we wrote about in our Fourth Quarter 2016 newsletter. We monitor volatility and as we suggested in our last newsletter, we considered 2017 abnormal due to the S&P 500’s consistent low volatility.

Although painful, we believe periods of volatility, like February 2018, provide opportunities for us in a number of ways. First, lower prices can give us the opportunity to make a specific investment in something we found attractive, but more attractive at a cheaper price. Second, we may sell something in a low volatility market, which has risen a lot, knowing that the investment has surpassed a reasonable fair value. Third, volatility may lead to such a dramatic rebasing of the overall market, that certain whole sectors become very attractive, and we can position the portfolio with whole sectors over

Graph 1: VIX Pricing

weighted or underweighted – like we did with the consumer discretionary sector in February of 2009. So even though these periods seem uncomfortable, we embrace them for the above reasons as well as others.

The level of discomfort may have reached a high for investors on February 5, 2018 when the Dow Jones declined 1,175 points, as seen in Table 1 below. The media headlines blared on that day pointing out that the Dow had suffered its largest point decline in history. Although true, February 5th ranked as only the 99th largest percentage decline in history. Again, this was a painful move that all of us would rather not experience in the moment, but we must keep perspective of the move in percentage terms and in terms of the period it occurred. In this case we had experienced a 20% plus up year in the S&P 500 in 2017 followed by a 5% up month in January. So does a 5% one day drawdown necessarily imply a change in market paradigm? No and as investors we get paid for bearing this volatility.

Table 1: Dow Jones Industrial Average Percentage Decline versus Points Decline

Historically the market has returned about 6% per year above a risk free rate. We believe that excess return comes as result of living with regular volatility. Fortunately for you, we embrace the volatility and attempt to make the investment decisions that take advantage of it. We know with certainty that what we all experienced in February will occur repeatedly in the future. As such, we will continue the approach we have taken over the last 40 plus years attempting to protect and grow your assets. Thank you for your continued trust!