A Note on Volatility

The below was previously sent to clients on February 5, 2018. What a difference 10 days makes!

Volatility has returned to the equity markets. It has been about two years since the major equity indices have seen this type of volatility, so it can feel like quite a shock. The first few days of the equity market decline were attributed to rising interest rates, but today’s selloff occurred in the midst of falling rates and no major news. As of this writing, the benchmark S&P 500 is down nearly 10% from its all-time high just 10 days ago. It is a large enough decline to take us back to…. December prices. This is an important point: equities have had an incredible rally over the past two years and it is not surprising that we are seeing some volatility and a pullback. Arguably, it would be more surprising if the market marched higher unabated.

There may be wilder swings to come (perhaps a snapback rally or a continued steep decline), but a few days or weeks of volatility should not be cause for panic. Despite the change in volatility regimes, many things have not changed:

  • Markets move up and markets move down, sometimes for fundamental reasons and sometimes based on nothing more than investor sentiment.
  • To generate returns, investors must expose themselves to risk. Today’s volatility is the price equity investors must pay for the generous returns of the past two years.
  • As we have said in the past, the time to make portfolio adjustments is before markets move. By the time the market drops 5% in a matter of minutes, it is too late to adjust your portfolio. Rather, select an appropriate asset allocation and perhaps reduce risk when markets are euphoric; you may miss out on some upside, but will be better equipped to exploit opportunities when the tide turns.

Notwithstanding the above, we are not dismissive of the recent declines. We are monitoring global markets and incoming data and are prepared to change our approach and strategy as the data dictates. If you have questions, concerns, or would like to discuss market specifics, please do not hesitate to reach out.

Yield Curve Spreads

One of the many challenges facing investors is separating the signal from the noise, especially in an age with a thousands of data points (and increasing thanks to a growing collection of "big data"). Much of the data out there is highly volatile (what we call "stochastic") and of minimal value, if at all. One of the few data points that we find useful to keep tabs on is the 2s10s spread.


The above chart shows the 2s10s spread, which is the difference between the 2-year Treasury yield and the 10-year Treasury yield.


Above is a graph of the underlying 2-year and 10-year yields. The 2s10s spread (the first chart) is simply the red line minus the blue line.

The reason that I and many other investors (and economists too) reference the 2s10s spread is that it is a quick and simple indication of the slope of the yield curve, which is used to measure and estimate all sorts of things. Generally, the economy and markets tend to do well when the yield curve is steep and not so great when it is flattish or inverted (meaning the short-end of the yield curve is higher than the long-end).

The first chart shows the yield curve is rapidly flattening, which is of particular interest these days since the yield curve typically flattens and then inverts just before recessions (as indicated by the gray bars). This usually occurs because the 2-year yield rises much faster than the 10-year yield (as is happening now) and eventually surpasses it. The yield curve is not inverted yet and rapid flattening often coincides with tremendous economic and market performance; it does not appear that the curve will invert for at least 6-12 months (if it does at all), so no need to panic yet.

It is worth mentioning that some of the smartest asset managers out there think that the yield curve conveys less information now than in the past, due to a variety of reasons that I won’t get into here. Those managers may very well be right, but the 2s10s spread has a much better recession-calling record than anyone I know of. Further, past episodes of yield curve flattenings and inversions were “explained” as benign signs by the top minds during those respective times. Of course, we do not need to constrained to only using 2-year and 10-year spreads, as it is illuminating to look at the entire Treasury yield curve as well. One way to look at it is below:

Treasury Yields Over Time.png

Treasury yield spreads are just a few of many data points and we're neither supporting nor denying their significance. It is something that many people watch and we believe it bears watching as well.

Donor-Advised Funds

An important tax planning and charitable giving tool is the Donor-Advised Fund (DAF). There are hundreds of DAFs offered by non-profits, community and corporate foundations, and so on. Since DAFs are sponsored by 501(c)(3) non-profit organizations, donations:

  • are irrevocable
  • may be tax-deductible

However, DAFs are “donor-advised,” which means that donors may continue to direct:

  • investment decisions
  • grant recommendations

Tax Benefits
Donors receive an income tax deduction when assets are donated into the DAF, but may continue to “advise” the DAF on investments and grants. Effectively, this means that donors can still direct how the assets are invested and granted.

Timing Benefits
The assets can remain in the DAF indefinitely before being granted out to the final 501(c)(3) non-profit. Thus, a donor can donate assets this year, but does not need to decide on the final non-profit recipient this year. The donor can decide where to direct the grant next year or in 10 years or beyond.

Other Benefits

  • Many DAFs can accept complex assets (such as real estate or business interests) that smaller non-profits are unable to handle.
  • If anonymity is desired, grants can simply be reported under the DAF and not from the original donor.
  • Once donated, assets can be sold without incurring capital gains tax and/or any future growth is tax-free.

A Flexible Solution
Investment considerations and tax planning often determine how and when to maximize the tax value of donations. However, these factors may not align with the charities that one supports. For instance, what if a charity is unable to accept stock options? Or perhaps a charity could use more recurring monthly donations rather than yet-another-lump-sum donation in December? A DAF is a great vehicle that can solve for these and other challenges.