Thoughts on Recent Market Volatility: Five Key Points

Market Volatility: Five Things to Know
Written by J. Cannon Carr, Jr. on October 14, 2014

Markets have been unkind since mid-September. The S&P 500 is down about 7% since hitting all-time highs, small stocks are down more than 10%, and investors flocked once again to US and German government bonds.

Most investors were weathering the storm, but by middle of last week we detected greater concern. Forecasts of doom were starting to gain more attention. The reality is that, despite headline risk and market volatility, we believe true fundamentals move much more slowly.

For detailed investment analysis, see the following two links: large cap report and small cap report. Our Fundametrics® research system is working as expected, despite the environment.

At a higher level, here are five quick thoughts on the past few weeks:

1.      Fear artificially ccompresses people’s investment horizons.

We should first point out that fear has a dramatic impact on human behavior. As we illustrate in our blog post (follow this link), fear can serve us very well as a survival instinct, but it can be disastrous when it comes to investing.

The problem is that it is human nature to fear loss, and fear compresses our time horizons to weeks or months. That orientation does not align well with stocks, which can be out of favor at any given time. Fear makes people sell when stocks are down, and “anti-fear” (i.e., greed) makes them buy when stocks are already up.

That’s why an investment strategy is vital. If properly designed, it should balance your near-term fears with your longer-term aspirations. Both stocks and bonds are tools that belong in your portfolio. Once this balance is set, investors should let the strategy work to meet their goals.

The bottom line here is that we have set an investment strategy for each client that strives to accommodate market swings that are worse than what we are currently encountering.

2.      Despite at times dramatic volatility year to year, stocks continue to behave as expected over longer cycles.

Markets have done exceptionally well over the past five years. The S&P 500, for example, has averaged about 18% annualized returns, without a down year. This return is double the long term average and is arguably unsustainable. It is prompting some people to predict that markets are due for a correction, particularly if economic growth is weaker than expected.

Taking a broader view, however, annual returns over the past ten years have been 8%, pretty close to historical annual returns of 9% since the 1920s. This is a bit more realistic since it includes the recession of 2007 and the credit crisis of 2008. The current rally occurred after one of the largest market shocks in history, when valuation multiples plummeted to single digits. Valuations have finally returned to more normal levels.

What the markets do in the next few years is anyone’s guess, but our point is that while stocks are volatile for any given year, they do tend to trend toward their long term averages. This is why it is important to stay with an investment discipline. You simply can’t predict when to like stocks or not.

3.      You can’t control the markets, but you can control spending.

The strong rally has helped us catch up to more historical trends, but it should not lull families and nonprofits into spending above plan. It is easy to draw down more than planned when portfolio returns are exceptional, but investors can be caught off guard when markets drop suddenly.

The key is to keep the right balance between the long term investment objectives and annual withdrawals from the portfolio. We have worked actively with clients to stay within a spending policy given the market’s dynamism.

4.      Stocks and (government) bonds face opposing risks; the average portfolio must be designed to address both.

Stocks and bonds, almost by definition, behave differently to each other. But with rates so low today, their opposing risks are all the more acute due to extreme possible outcomes for each:

  • Bonds win if economies continue to weaken. In particular, cash and government bonds win if deflation[1] occurs, and stocks can get hammered.
  • In contrast, stocks win with better economic growth and steady inflation. Severe inflation would favor hard assets. Supposedly safe bonds can get hammered.

The challenge is that the case for either scenario—deflation or inflation—can be made. Which should you pick? Or when do you swap?

  • While the world has made great strides, we still see the structural challenges (high sovereign debt, low economic growth, weak industrial policies) uncovered by the financial crisis of 2008. Sustained economic weakness and little remaining “policy ammo” could mean deflation, as experienced by Japan for 20 years.
  • At the same time, we see ample proof that economies have healed to some extent (particularly in the US). Lower energy prices should help.

Our own view is that, despite the ugly effects of deflation, global credit markets will continue to function (no return to the liquidity crisis of 2008 on a global scale) and that economies are gradually healing (although there will clearly be challenges). We believe INFLATION has the higher probability over the next 5-10 years.

Nevertheless, it is a trap to position a portfolio for one outcome exclusively. This is why we build diversified portfolios to match nearer term needs for stability with longer-term needs for growth.

5.      We have adjusted portfolios to the changing valuation landscape along the way.

Over the past five years, we have followed our discipline of selling overvalued stocks (and other specialty asset classes) and trimming allocations back to strategy targets. Selling when an investment surges and buying when it lags keeps the overall investment goals in-line.

When we see valuation extremes—as we did when small stocks became less attractive to US stocks and emerging international equities last fall, or when low rates did not favor long term bonds five years ago, or when the quest for safety rendered high dividend stocks, MLPs, or US REITs unattractive in 2010—we make appropriate tweaks to strategy. These two principles—rebalancing to strategy targets and “tilting” strategy on those rare extremes—are keys to achieving the long-term return goals of the portfolio, in our view.

[1] Deflation occurs when prices broadly fall as money fails to pump through the economy (little credit extended, people don’t spend as they wait for lower prices). This combination of falling prices and weak demand can be a protracted circle of events, leading to severe recession. It is particularly dangerous with high debt levels, since loan amounts don’t change yet repayment gets more difficult.

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