Over the course of this year, we have spoken and written numerous times about how rare of a year 2017 was in terms of market volatility. With US markets rising around 20% and foreign markets rising nearly 30%, investing seemed risk free and easy.
While us saying this is one thing, we wanted to offer some additional perspective and evidence on what has and continues to transpire.
Days like yesterday (Thursday, 10/25) give hope that the drawdown is over and a recovery has begun, but the reality is that we simply do not know when the recovery will fully take stride, and there very well may be more turbulence along the way.
First and foremost, for those that want the deeper dive, here is a link to a recent article by Larry Swedroe, the Director of Research for the BAM Alliance: An Awakening Bear? I highly recommend it for those that have the capacity and interest in understanding further. He has been at the forefront of BAM and the investment research community for decades, and is among the rare people that is extremely well respected in both the academic and investment communities. Further, his commentary is always specific to the style of investing we employ.
Among the many notable comments Larry provides in his article, he offers the following chart of market declines of 5% or greater during a calendar month since 2009:
In essence, these drops are not all that uncommon. In fact, prolonged drops that can last several weeks are not either, as evidenced by the consecutive months in 2010 and 2011. In addition, the 2016 decline actually lasted well into February, but had recovered by the end of the calendar month and therefore, is not included.
This is why investing is risky and hard, and why behavior and rebalancing is so important. These drops were all sharp, and in some instances, lasted a little while. Yet in each case, the recovery was very rapid as well.
We live in a series of short-term moments, inside of a long-term life, so even though long-term, disciplined investing makes sense to most people, living that out in short-term moments is really, really hard to do.
I can’t begin to tell you how many people I have talked to that wanted nothing to do with the US market (1) after 2009, or (2) at election time in 2016. But now in hindsight, they kick themselves for not being 100% US stocks the whole time! You can’t invest in hindsight, and you can’t go back and buy past returns.
As the global stock market continues to be in the midst of its second rapid dive of 2018. While that may seem pretty extreme, as the esteemed author Morgan Housel reminds us in his tweet above, it only feels extreme because it hasn’t happened for awhile. Recent events heavily skew our reality (recency bias), especially when it comes to investing.
In a separate recent blog, prolific investment writer Michael Batnick of The Irrelevant Investor highlights the following:
He writes “over this 29 year period, there were 500 more up days than down days, which was enough to produce a 669% gain for the index (without dividends).”
In addition, he further outlines that the average up and down days during a bear market are about twice as severe as a bull market, which is what makes staying disciplined in times like this so darned hard. However, the importance of that discipline is evidenced in the chart from Mr. Swedroe above.
It also underscores the validity of the quote by famed investor Shelby Davis that “you make most of your money in a bear market, you just don’t realize it at the time.”We are seeing more and more questions in the media (and with some of our clients as well) about whether international investments are necessary given the dominant performance of the S&P 500 in recent years (with the exception of 2017, of course), and the difficulty foreign markets have had in 2018.
We readily and fully admit – being diversified is HARD! Investing is hard. When the US market is rocketing higher, diversification drags returns. And when the market rockets lower, it still does what it is supposed to do and drags returns, but that usually doesn’t feel any better as things are simply moving south a little slower.
The reality is that your bonds are doing what they are supposed to do right now, and when the dust settles, will help ensure you are on the correct side of the math equation.
They are not exciting in rising markets, nor are they particularly exciting in times like this. But they are critical as a store of value right now, and they give you some resources to buy stocks at these depressed prices with.
We are looking at your allocations very closely right now, and are moving swiftly to rebalance and harvest tax losses where appropriate.
As we continue to work through this, remember the following:
Know your long-term plan incorporates market risk. When we work with you to determine an allocation, part of that process involves examining that portfolio’s historical risk. This historical experience covers decades and therefore incorporates things like the financial crisis of 2008-2009. This data shows that equity markets experience declines in about 25 percent of quarters and in about 15-20 percent of years. Experiencing this risk is why markets have also rewarded long-term stock market investors with higher returns than safer investments like fixed income. In addition, the risk we are currently seeing is well within historical ranges for all the portfolio allocations we utilize.
Second, know that predicting short-term market movements is virtually impossible and making portfolio adjustments in response isn’t wise. Over and over, academic research has shown that no one appears to be able to reliably forecast short-term market movements. As Warren Buffett famously said, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Don’t forget that we had a significant decline in the S&P 500 in late January/early February of this year. Many predicted the U.S. market would continue to decline from there, but that period was instead followed by very strong U.S. market returns until mid-September..
Third, the stock and bond markets are aware of the Fed’s plans to continue increasing the federal funds rate. One particular concern we’ve heard some investors express is the fear that continued increases in the federal funds rate will cause either the stock or bond market to fall further. We’re skeptical of this claim since both markets seem to be fully aware of the Fed’s plan given it has been clearly articulated for well over a year. It’s also important to understand that most bond strategies that we utilize in client portfolios have relatively low sensitivity to interest rate changes, and are holding up very well in the current environment.
Fourth, we’ve also heard concern about trade. No doubt, there is increased risk of trade retaliation, but that is one of the primary reasons markets are off their highs from earlier in the year, and a major contributor to emerging markets performing so poorly relative to developed markets. It would be misguided to believe that these risks are unknown to the market or have been mispriced. The market is aware and has already priced in at least a certain degree of trade risk. Trying to outguess the market isn’t productive.
Fifth, remember that your stock fund allocation is globally diversified and your fixed income allocation is expected to buffer stock market risk. The performance of your stock fund allocation is not solely driven by the performance of the U.S. market but rather by the performance of global equity markets. It’s completely within the realm of possibility that the risk experience from here could be elevated for the U.S. market compared with other markets, as we are running are very high valuations in the US, but relatively low valuations overseas. This is one of the reasons why we’ll always advocate global stock market diversification, since we have no way of knowing which particular country will generate the best long-term returns.
Finally, we maintain a very high-quality approach to the fixed income portion of your portfolio. More often than not, when the stock market does decline significantly, the fixed income portion of your portfolio will either be holding its ground or appreciating, providing a risk-reduction benefit.
Hang in there. And for what it is worth, at the present moment I am far more concerned about our clients’ well-being and emotional state during this correction than I am about the market or the portfolios themselves. This too shall pass, and we will make sure you are positioned well to recover.