Market volatility reached a fever pitch in October, creating anxiety for equity investors. Although few believe the U.S. economy is on the verge of a recession, many are worried that last year’s synchronized economic growth has passed its peak.
The contrasts between 2017 and 2018 are noteworthy.
The U.S. stock market advanced at a steady pace in 2017, with only a few days in which the market moved by more than 1 percent. 2018 is a very different story. Equity moves of 1 percent or more seem to be a regular occurrence, and October’s losses erased most of the equity gains from the first nine months of the year.
In times of market turbulence, it is important to resist the natural impulse to react emotionally. The following six tips may help investors to stay on a sustainable investment path.
Remember that volatility isn’t unusual. Since 1979, the average annual number of market moves of 1 percent or more was 62. Consequently, this year is really a “normal” year in terms of volatility, while last year can be thought of as a historical outlier.
The recent downturn in equities may also be painful after last year’s steady advance, but market corrections are also a normal occurrence. The average intra-year decline of the U.S. stock market was 14 percent since 1979, and equities declined by 15 percent or more about one-third of the time. Despite these considerable intra-year declines, calendar year returns were positive in 33 of the past 39 years.
Accept that market timing is a self-defeating practice. The temptation to time the markets is hard to avoid, but market timing typically detracts from portfolio returns. Morningstar’s annual study of 20-year returns is a helpful and consistent illustration of the perils of market timing. Investors in the U.S. equity market for the full 20-year period through the end of 2017 earned 7.2 percent per year, while investors who missed the 10 best days saw their returns cut in half.
Although avoiding the 10 worst days would boost returns, the best and worst days tend to be clustered together. Unfortunately, there are few (if any) investors able to trade with the perfect foresight to capture the upside and avoid the downside.
“Sitting out” the end of a bull market is another form of market timing. Some investors say they are willing to accept “leaving some money on the table” by pulling out of equities in the latter stages of the bull market. The challenge with this variant of market timing is that bull markets don’t have predetermined start and end dates.
Missing the final stages of a bull market can be costly. In the last 12 months of every bull market since the 1970s, equities provided double-digit gains. Returns in the final 24 months were even more robust.
A further complication is that investors who move to cash also have to determine when to reinvest in equities. Some of the investors who moved to cash during the global financial crisis are still waiting for the “perfect” time to redeploy cash back into equities. Wise investors realize that time in the market is more important than timing the market.
There is more to the markets than U.S. equities. International stocks have lagged U.S. stocks for much of the last decade. International stocks were strong performers in 2017, but the rally stalled earlier this year, in part because of tariff fears.
Some investors are revisiting their commitment to global diversification, which may be a mistake. Some of the best companies and most interesting long-term growth opportunities, can be found outside the U.S.
China represents about 30 percent of the world’s economic growth, and technology leaders Tencent Holding, Alibaba Group Holding ( BABA) and Baidu ( BIDU) are among the most innovative companies in the world. Consumer goods giants such as Nestle, Unilever ( UN), BMW, Toyota Motor Corp. ( TM) and Honda Motor Co. ( HMC) are global brands. Inditex, the parent company of Zara, and Fast Retailing, parent company of Uniqlo are among the world’s most creative retailers. The pharmaceutical sector includes global leaders such as GlaxoSmithKline ( GSK), AstraZeneca ( AZN), and Novo Nordisk ( NVO); the energy sector includes BP ( BP) and Royal Dutch Shell.
Leadership in the equity markets has historically rotated among regions, and it is a mistake to count the rest of the world out. It wasn’t long ago that the 2000s were spoken of as a “lost decade” for stocks. That statement may have been true for those invested only in U.S. large company stocks, but the 2000s were anything but a lost decade for those who invested in international, emerging markets and small company stocks.
The Fed isn’t loco. President Donald Trump has been critical of rate hikes by the Federal Reserve. However, Fed policy is appropriate given the economic environment.
Although core inflation remains near the Fed’s 2 percent target rate, there are indications of rising inflation. Tight labor markets are creating long-overdue wage growth, fiscal stimulus may contribute to inflationary pressures and tariffs tend to be inflationary. Federal Reserve Chair Jerome Powell is also worried about potential asset bubbles, a necessary concern given that past periods of “easy money” gave rise to excesses in commercial and residential real estate, technology, and commodities.
Today’s macroeconomic imbalances appear less severe than those in recent memory, but it’s logical for the Fed to want to prevent things from getting out of hand. Policy mistakes made by past Fed chairs under pressure from the Oval Office contributed to the “stagflation” that crippled the U.S. economy in the 1970s; the Powell Fed will try to avoid a repeat of that sad chapter in Fed history.
The next bear market may not be like the last two. The peak-to-trough decline of the S&P 500 during the financial crisis was 56 percent, and during the dot com bust was 50 percent. Both bear markets lasted longer than one year.
The common assumption is that the next bear market will be similar to the last two, but that expectation may be overly pessimistic. Historically, the “average” bear market decline since 1953 was 31 percent and the average duration was eight months. Painful, yes, but not as destructive as the two steep and protracted bear markets during the 2000s.
Volatility, by itself, isn’t necessarily harmful to investor portfolios. Harm results from permanent loss of capital associated with making bad investments or selling at inopportune times. Investors can reduce the likelihood of a permanent loss of capital by avoiding self-inflicted causes.
Investors are more likely to weather periods of market volatility by holding well-diversified and periodically rebalanced portfolios, maintaining the liquidity necessary to avoid being a forced seller, and having the emotional control to avoid panic-related selling.
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable.
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