Posts tagged Market Volatility
After a period of relative calm in the markets, in recent days the increase in volatility in the stock market has resulted in renewed anxiety for many investors. From September 30–October 10, the US market (as measured by the Russell 3000 Index) fell 4.8%, resulting in many investors wondering what the future holds and if they should make changes to their portfolios. While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a normal part of investing. Additionally, for long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the drawdown itself.
Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 33 years out of the 39 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.
Reacting Impacts Performance
If one were to try and time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance? If current market prices aggregate the information and expectations of market participants, stock mispricing cannot be systematically exploited through market timing. In other words, it is unlikely that investors can successfully time the market, and if they do manage it, it may be a result of luck rather than skill. Further complicating the prospect of market timing being additive to portfolio performance is the fact that a substantial proportion of the total return of stocks over long periods comes from just a handful of days. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, the prudent course is likely to remain invested during periods of volatility rather than jump in and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.
Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index going back to 1990 and illustrates the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1,000 over the period and show what happened if you missed the best single day during the period and what happened if you missed a handful of the best single days. The data shows that being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer.
While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful. By adhering to a well-thoughtout investment plan, ideally agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty.
Tariffs, trade wars, interest rate hikes, the Facebook data scandal, the omnibus spending bill…Today’s headlines are filled with market turmoil and it appears that everyone is tuning in. The question many investors are asking is “Should I be concerned and if so what should I do about it?”
The market is volatile, there’s no doubt about that. Volatility is normal, it is to be expected. The challenge that many investors face is that they are bombarded on all fronts by stories, opinions and so called expert recommendations. In today's on-demand era, “wait and see” can be a frustrating tactic. Yet consider it this way: Markets discount widely-known information. Expectations for $60 billion in tariffs and corresponding retaliation from China are probably baked into prices now. If Thursday’s volatility is any guide, investors are generally unhappy with this possibility. But as markets look forward, they move most on the gap between expectations and reality. Compared to what people evidently fear today, even watered-down tariffs would be a positive surprise. Heck, even simple math might be a positive surprise: $60 billion amounts to just 2% of total 2017 imports. That’s not a lot. If China retaliates in kind, they would apply further tariffs to just 2.6% of the US’s total 2017 exports which is also not a lot. Seems to us like there is a lot of room for negative sentiment to catch up to a more benign reality.
Most people are long term investors who are targeting a specific rate of return based on their individual goals. What people often forget is that when targeting an annualized rate of return you will have vast differences in year over year returns. In fact, there are few years when either stocks or bonds delivered returns that are even close to the market averages.
To illustrate this point, between 1926 to 2016 the annualized return for U.S. stocks was 10.16%. During that time returns fell within 2 percentage points of the annualized return of 10.16% in only 6 of the 91 years.
When considering the U.S. bond market, between 1926 to 2016 the annualized return for the U.S. bond market was 5.37%. During that time returns fell within 2 percentage points of the annualized return of 5.37% in 24 out of 91 years.
Financial markets, particularly stocks are inherently volatile over the short term, as we are once again experiencing.
When we understand, and come to peace with this data, we can begin to understand equity volatility as a positive phenomenon, and in fact the reason for the premium return from equities. The term “volatility” refers to the relatively large and unpredictable movements of the equity market, both above and below its permanent uptrend line. Equities can, and frequently are, up over 20% one year and down 20% the next, and vice versa. However, if we accept that the long run returns of equities will approximate the past return, we begin to understand that these periods of downside volatility must likewise at some point be corrected by a period of upside volatility, greater than the long-term average of roughly 10% per year.
The premium returns of equities are, therefore, the efficient market’s way of pricing in adequate compensation for tolerating such unpredictability. Volatility is the reason equity investors are rewarded over time with premium returns, as long as we have the emotional strength to live through it. Volatility is not to be survived, it is to be embraced and thrived upon.
You Have a Plan
The very best investors have a disciplined approach to making portfolio decisions, and always stick to their plan, no matter what the rest of the world is doing. They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.
No predictions. No witch doctor investment sorcery or magic investing formulas. No “Black Boxes.” Just hard work, patience and discipline.
“Ladies and gentlemen this is your Captain speaking. It appears we’ve hit a bit of turbulence. For your safety and for those around you, please stay calm, seated and keep your seatbelts securely fastened”.
If you fly enough, you have undoubtedly heard an airline Captain say these words. Many passengers would find it more comforting to hear the Captain say the following: “This turbulence is normal and is to be expected. We never know when it will hit or how long it will last, yet it’s important for everyone to know that we built this into our flight plan before takeoff. Please know that we are making the necessary adjustments to our flight plan which are based on the fundamental principles of flying. I understand this can be a bit frightening, however it is important that everyone remain seated and calm. While I also know that it feels like this time it’s different, it’s not. This is normal and we will pass safely through it. And as a friendly reminder, we’ve experienced this turbulence many times before during our flight and we’ve always made it through okay.”
The same advice can be given about the recent events in the financial markets. Turbulence must be expected and investing is never a smooth ride.
The volatility we are experiencing this week is normal. In fact, since the beginning of this prolonged bull market which began in 2009, there have been 9 times that we have experienced this type of volatility. The three most recent pull backs are highlighted below:
January 2016 – Over the course of three weeks the S&P Index was down 11 percent and by April of that year all the January losses were gone.
August 2015 – A 1,000-point drop in the DJIA on August 24th. The S&P lost 11 percent over the course of six sessions only to recover the losses in the next two months.
October 2014 – There was a 460-point rout in the Dow average on Oct. 15, widening a selloff that started a week earlier to 5 percent. The rout faded as quickly, and the Dow recouped all the losses in the next two weeks.
Even for the most disciplined of investors, this week’s market volatility is bound to strike up some negative emotions. This is completely normal. The key is to not act on those emotions or make irrational decisions.
What is causing these market moves?
U.S. equities have had an unprecedented run and we were overdue for a correction. Since the election in 2016, the S&P 500 gained 32% peaking on January 25th without any substantive pullback. In the month of January alone, the S & P 500 ran up 7.4% to a new high before experiencing the current market turbulence. These upward moves, while pleasant to investors, are unsustainable without consolidation. Even though the economy looks promising going forward, corporate profits are rising, and tax cuts should spur additional growth, the financial markets simply got ahead of themselves. The economic fundamentals are still intact and we see no signs of a slowdown on the horizon.
Investors had become complacent. As the equity markets reached new highs, many more investors piled in pushing the markets up further. We saw risk parameters of investors change, eschewing the safety of bonds for big gains in equities. These investors lost sight of the fact that stocks could be volatile and as quickly as they piled in, they are retreating. Additionally, the Bitcoin phenomenon has taken on a life of its own. We believe this is the epitome of speculation. Speculators piled into Bitcoin driving it up to over $19,000 looking for quick gains. Most people who invested in this cryptocurrency did not understand the fundamentals, they did it to make a quick buck. As of this writing Bitcoin is valued at $8,300. The risk of stock investing was not enough for these cryptocurrency speculators, they wanted more risk and got burned. We do not invest in cryptocurrencies at JJBCO but we use investor sentiment in it as a gauge of fear and greed in the overall markets.
Interest rates have been rising and this has a tendency to scare equity investors. Since September of 2017, the yield on the 10 year US Treasury Bond has increased from 2.06% to 2.85%. Why would this be a concern? Markets get nervous when yields rise because of competition for investment dollars. If an investor has an opportunity to lock in guaranteed income at higher rates they may be less likely to take the risk of investing in stocks. We believe the orderly increase in bond yields is a good thing. It shows that the economy is strengthening and it will allow our clients who need retirement income to meet their needs without subjecting themselves to undue equity risk.
At the end of the day this market turbulence we are experiencing is not unprecendeted….it is normal. Yes, it is unpleasant to go through and it will shake some weaker hands out of the market. The key is to have a target allocation and a plan. Many investors just react with emotion because they do not know what they are investing in or the goal they are investing for. We build portfolios on sound fundamental principles of investing which include:
Asset Allocation – The long term mix in your portfolio of stocks, bonds and cash.
Diversification – Within each asset class holding a globally diversified portfolio built upon the dimensions of returns.
Rebalancing – The simultaneous buying and selling of assets to maintain your target allocation and manage the risk inside your portfolio.
What happened in the markets over the last two weeks is normal. There is no need to panic. The fundamentals of the economy have not changed. If you have any questions or wish to speak to us directly please feel free to contact us.
On behalf of your NY based flight crew, this is your Captain signing off.
Everyone is afraid of something. It’s true. The visceral reaction to threats, real and imagined, has driven human behavior for millions of years. As time has passed, our species has evolved from fearing simple threats from predators and harsh climates to fearing more sophisticated threats. We have mostly conquered our ‘lizard brain.’ The lizard brain (so called because it is believed that reptiles survive almost solely on its impulses) is the amygdala, which controls emotions such as fear, our survival instincts, and memory. Controlling fear is how our ancestors emerged from the cave and conquered predators and darkness. Now, millennia later, what are we most afraid of? According to Chapman University’s 2016 ‘Survey of American Fears,’ Americans are most afraid of government corruption than any other of the additional 79 topics in the survey. That’s right: we are more afraid of our own government than we are of death, disease, loneliness, war, climate change, going bankrupt, snakes and public speaking. This year, it appears, we are also afraid of our future.
Some of our recent discussions with clients have surfaced their biggest fear: the outcome of our national elections on November 8. As we might expect, investors are worried about the future because of heightened dislike for many of the candidates and an uncertain future for the economy, the markets, and their portfolios. Their collective lizard brain says sell stocks and hide, much like our primitive ancestors, and emerge when the perceived threat has passed. As we often say, we understand this reaction. We know that the markets, like people, hate uncertainty. We also know that managing our emotions – especially conquering fear – in trying times is the key to success in any endeavor. So it is today.
Remember that the market has weathered many crises since 1900: two world wars, the Roaring ‘20s, the Great Depression, the first big market crash in 1929, oil shocks, wars in Korea, Vietnam and the Middle East, the 1987 flash crash, the Tech Bubble, high inflation, low inflation, terrorist attacks on U.S. soil, the Financial Crisis, a government debt downgrade, landing a man on the moon, the Ebola and Zika scares, ISIS, the beginnings of climate change, banking crises, the rise of the internet, the rise—and fall—of communism, and so on. Through all these events, capitalism has survived and adapted and moved forward. We believe it will again regardless of Tuesday’s election results.
Here’s our brief summary of the main issues to consider when thinking about the election and the post-election markets:
The U.S. economy is chugging along in a low-growth/low-inflation environment. A recession is not on the IMMEDIATE horizon, interest-rate hikes are expected to be modest and drawn out, and the job and housing markets are stable. Preliminary Q3 GDP came in at +2.9%. As we write this, October’s payrolls number was good and included prior-month positive revisions, unemployment dropped to 4.9% and wages showed their highest year-over-year increase since 2009 (ending at +2.8%). Even market news is good: S&P 500 earnings results thus far for the third quarter of 2016 are showing improvement over the past six quarters. These data show expected improvement for the current quarter and into 2017.
The Fed is expected to use the calm after the election storm to raise short-term rates by 0.25% in December, with two additional +0.25% hikes expected next year.
The markets, and a narrow majority of the electorate, appear to favor the Democrat candidate. Mrs. Clinton has proffered a platform of change, but nothing that we see as too radical. We expect that, should she win and the U.S. Senate change control, that modest incremental legislation will be enacted to (among other things) change the tax code, work on regulatory and immigration reform and review U.S. trade pacts. The markets have, and should continue to, respond modestly.
Many of our clients have stocks and bonds in their portfolios. The stocks are expected to provide long-term growth to keep ahead of inflation; the bonds provide income and act as ballast when markets are especially volatile and investors seek safety. Adjusting this mix by using rebalancing opportunities is our best tool to keep our strategic focus and avoid costly tactical mistakes. This is what we do.
Investors need to battle their lizard brains and keep their focus on the future, not the short term. The initial fear trade is to sell and go to cash; a tried and true short-term palliative, selling stocks and sitting in cash is good for short-term peace of mind but not a long-term planning strategy. Our clients know that we believe in globally diversified portfolios, that we focus on the long-term, and consider strategy over tactics to ensure that portfolios are built to stand the weather of time rather than simply avoid today’s storm.
As always, we appreciate your confidence and would be happy to discuss any of the issues raised here or answer any questions you may have.
In an expectedly close but surprising vote, the U.K. has completed a referendum to endorse a withdrawal from the European Union (EU). Today’s market reactions are the usual result from market uncertainty around economic issues—sell-offs in “risk assets" such as stocks and currencies and a flight to quality in “safe-haven” currencies and bonds (e.g. the U.S. dollar and Treasuries). Early analysis of the results indicates, however, that the LONG-term results may not be as severe as feared.
HERE’S WHAT HAPPENED
U.K. and Commonwealth voters, by a slim margin, voted to leave the EU. Prime Minister David Cameron immediately resigned, and a new government will be installed in the fall.
WHAT HAPPENED IN TODAY’S MARKETS?
Stocks and other assets such as currencies, have sold off around the globe. The U.K. and other EU countries have been hard hit, while the U.S. decline has been muted. Leading up to this, the global markets were rebounding over the last couple weeks.
The U.S. dollar and Japanese yen have strengthened; the Euro has declined a bit, and the sterling has substantially declined against the dollar.
There has been a flight to quality in bonds, particularly U.S. Treasury Bonds.
Gold has been priced up, while oil has declined.
WHY WERE MARKETS VOLATILE?
Many believed that Britain would remain in the EU and short-term traders made heavy bets in currencies and other “risk assets.” In fact, markets rallied into the vote as the DJIA was up over 250 points yesterday. Interest rates were moving higher.
The markets were surprised once the votes were tallied and markets reversed their trend, giving back most of these gains. The behavior was violent as Britain leaving the EU is a significant event.
The U.S. markets declined as the thought process that European companies are trading partners of the U.S. This could be negative for some businesses.
WHAT ARE THE LONGER-TERM EFFECTS?
Britain represents 4%-5% of global GDP. Net results may not be that significant.
The U.K. will need to implement policies to provide liquidity and ease interest rates.
The sterling will fall, U.K. inflation will increase due to increased import prices, and U.K. GDP will likely decline in the near-term. A recession is possible in Britain.
The U.S. will be relatively insulated. The Fed will likely delay interest-rate hikes.
Global growth may be affected to some degree. This event is not a ‘Lehman moment’ that accelerated the global Financial Crisis. As one pundit noted, “…markets adapt. Policymakers adjust. Businesses will change course while they continue to seek profits. Prices will reset. Opportunities will emerge.”
WHAT SHOULD BE DONE IN MY PORTFOLIO?
Our principles of portfolio construction are based on each of our client's unique personal goals. Their plan is well thought out and balanced by diversified asset allocation.
Changing your portfolio based on a reaction to market events rarely leads to productive long-term results.
All of our plans are built upon the certainty that we will go through negative events and market fluctuations.
All of our portfolios contain an anchor of high quality bonds and bond funds, which help to limit declines in significant market events, and did so during the Brexit vote today. Our bonds are doing exactly what we want in uncertain times.
We expect short-term stock volatility and will be partially offset by bond and commodities gains. Today’s market moves are short-term reactions, and most currency and bond markets have moved in orderly fashion (i.e. no extreme drops). And, as our pundit notes, “The long-term political, economic and financial repercussions of the ‘Leave’ vote are incalculable at this point.”
While the Brexit vote has been surprising and unsettling, most of the effects will be felt in the U.K. and Europe. We don’t see any required portfolio moves at this point; most of the trading is just that—trading. Long-term investors should stay focused, and we’ll update you as events progress.
As always, if you have any questions or wish to speak to us directly please feel free to call us.