October Market Volatility

As you arise this morning, you likely know already that the global stock market fell very sharply yesterday. It was the worst day for markets since this past February. The selloff continued overnight in foreign markets, pushing them downward toward their 20-month lows.

Predictably, the news media has a wide variety of things to blame for the simple reality that there were a lot more sellers yesterday than buyers, fueled heavily by machine-trading. Some blame interest rates rising, while others blame trade wars and tariffs, and others blame the Fed.

We need to stop trying to blame anyone or anything, and just accept that markets do this from time to time. Make no mistake, it does not feel good when it happens, but it is far more common than we realize.

And most importantly, times like this are why high-quality bonds are so important to have in a portfolio.

As a brief reality check, this is the 23rd time that the S&P 500 has dropped 5% or greater from its peak since March of 2009. On average, the recovery period has been 42 days. All of them seemed like the world was falling apart at the time. And each time, the market recovered.

For much of this year, growth stocks – and technology in particular – have been plowing well ahead of the broad market. We have discussed and written with many of you that the advance in these areas is not sustainable forever and that a correction is inevitable, but not necessarily imminent.

Over the past 18 months, we had been starting to hear echoes of some of the commentary being made in the 1990’s, most notably that there is a new era upon us, that fundamentals do not mean what they used to, and that diversification is not necessary.

Predictably, investors have continued to pour money into technology stocks and funds this year, which props the prices up further. However, over the past few weeks, over 80% of tech stocks falling into correction territory, defined as having declined 10% or more.

Chasing returns is a fool’s errand. You simply can’t buy last year’s returns. Rest assured that your exposure is relatively limited in the areas that are currently being hit the hardest.

Let this be a reminder to us all that this is what risk feels like. This is what we mean when we say markets are risky, and that we never want to take more risk than you need, or more risk than you can afford.

Historically, markets have experienced a correction of 10% or more every 11 months. We went about 24 months from February of 2016 to February 2018 without one, and while we haven’t reached correction territory yet, it would not be abnormal to experience a second drop of that magnitude in a calendar year.

As long-term investors, we must accept and absorb some of this risk in order to earn the upside that investing in financial markets provides over time. Investing carries risk. It is not, and never will be, easy. However, as asset allocators, we offset that risk with lower earning (but more stable) assets that do not carry the same level of volatility in these turbulent times.

Averages tell us to be aware and prepared, but because these declines do not come in any predictable pattern, the objective is not to try avoiding them, but to make sure you are positioned in a way that allows you to stick with your plan. In the words of Nobel Laureate Harry Markowitz, ““In choosing a portfolio, investors should seek broad diversification, Further, they should understand that equities–and corporate bonds also–involve risk; that markets inevitably fluctuate; and their portfolio should be such that they are willing to ride out the bad as well as the good times.”

We have been stating for a long stretch of time now that this party can’t last forever, but it is impossible to know when markets will correct or revert. We voiced concern when the market dropped back in February:

“We wrote and talked with you at length over the last year about how strange of a year it was, where volatility basically evaporated from the global markets. Stocks seemed to be riding a wave of positive economic news toward an endless horizon.

Corrections are a great reminder that when it comes to investing, we must engage markets with a heavy dose of humility, patience and respect for what markets can and can’t do. As soon as we think we have them figured out, we run headfirst into a wall. People prepare for risk events based on what they anticipate or see coming. But the reality is that risk is what you can’t see coming. Market corrections often seem to come out of nowhere, and they hit us fast and furious.

We have all been “waiting” for the market to correct. The majority of you have even offered that suggestion yourselves. Yet even as we were anticipating this to happen, portfolios have earned a very healthy sum of gains. In virtually every conversation we have been having with clients, we have been reminding you that this seemingly endless party will not last forever, but it can last a lot longer than we expect.

However, in recent weeks, we seemed to be talking more people off the proverbial ledge. This time around, instead of having to stop people from jumping out as the market drops, we were holding people back from increasing their stock allocations as markets rose. These conversations make me the most nervous.

It is a testament to you, as clients, that the bulk of our investment-related conversations over the last year or so have been the right ones. You are asking far more about risk exposures, whether portfolios have reached levels where we can reduce your stock allocation and still meet your long-term objectives, etc. Very few of you have been asking for more risk, or more stocks, and are instead concerned about being appropriately positioned for inevitable events such as the market drop this past week.

On the contrary, as the market has been rising, the general population wishes they had a riskier portfolio – a higher stock allocation. In addition, they tend to look at the relatively miniscule returns they are earning in bonds, and fear that they are missing out. We have to look no further than observing fund flows to see that people tirelessly chase returns.”

In recent weeks, echoes of February have been bubbling to the surface. Even though we all know that existing bond prices fall when interest rates rise, it is hard to stay with them when the media keeps telling us the market has reached record highs.

Indeed, the US Aggregate Bond Index is down (-2.5% year-to-date) on the heels of several interest rate hikes, while the US stock market has been mostly positive. Comparatively, our primary bond position, DFGBX, is up 0.25%. No, this is not exciting, but it is earning its keep this week.

Better times are ahead for bonds (and stocks), but we must be patient. Nothing in the investing world can be forced. As Warren Buffett states, “the stock market is a wonderfully efficient mechanism for transferring wealth from the impatient to the patient.”

On the whole, this year has a look and feel eerily similar to 2015, where virtually every asset class around the globe was basically flat or negative. You survived that and thrived in the years that followed. Stay calm. Accept that investing involves good years and bad years. You can absolutely afford to absorb markets like this, and we will ensure you are positioned for an inevitable recovery.

We have been through times like this before, and our investment philosophy has sustained itself through far worse. The exercises we go through in projecting your financial plan and determining your asset allocation include market shocks of a magnitude far greater than this. Recent events change nothing.

If trades are necessary to rebalance your accounts, we will be all over that, but there is no need for allocation adjustments or major changes in light of recent events. We have the team, tools, talent and temperament to execute the disciplined philosophy we have employed on your behalf in a timely manner.