Timeless Truths in Today’s Market

November 9, 2018

October lived up to its historical reputation as the most volatile calendar month, with wide market swings in both US and international stocks. This came alongside negative returns from bonds as well. The factors weighing on the markets aren’t new and include Federal Reserve rate hikes, trade tensions, election and political uncertainty, and the general awareness that we are likely in the later stages of the longest bull market in US stock market history.

Because we fully expect the market to behave unpredictably in the short term, we aren’t alarmed nor surprised by the recent volatility. But we also recognize that investors are being hit with a barrage of endless micro-focused financial news stories, so we thought it would be helpful to take a step back and offer what we believe are some timeless truths for any market.

Don’t be surprised by market volatility.

The recent volatility in the markets has understandably come with questions, such as, “Is this the start of deeper losses to come?” and, “What if any changes should be made in portfolios?” We don’t know if October is the start of further losses or not. We do know that stocks are volatile and, despite much of what we’ve seen over the last nine years, that includes volatility on the downside. We are also confident that the United States will have a recession again. It will likely take most market participants by surprise and therefore correspond with sharper market declines than what we saw in October. However, such declines in prices may create attractive expected future medium- to longer-term returns.

Stay disciplined but avoid stubbornness.

The patience and discipline that we often talk about as critical for long-term investment success are even more important as valuation-based investment approaches have been challenged during this extended market cycle. We continue to strongly believe that the price you pay for an asset is a key determinant of your long-term return. We also believe that in-depth fundamental analysis and independent thinking matter, and that a long-term horizon is necessary to be a successful investor. We continue to strongly believe that financial market cycles have not become obsolete, and that the current cycle will turn again as it always has—driven by underlying fundamentals, valuations, and the human herd behavior that drives markets to excesses. But for a disciplined process to work, you have to stick with it. If you become a performance chaser or a serial risk avoider, that is a sure path to investment failure.

With that said, our commitment to intellectual honesty also means we can’t be stubborn. We regularly question our assumptions, take in new information, retest our analysis, and continually ask what we might be missing and investigate it. We are always seeking to learn and improve, and sometimes good lessons come from this process. As an example, we recognize now that, coming out of the financial crisis in 2008 and beyond, we didn’t envision the extended quantitative easing by the Fed, nor the zero or negative federal funds interest rate. We didn’t fully appreciate the positive impact these policies would ultimately have on financial markets and asset prices—US stocks in particular—even though their impact on the actual real economy was modest (as reflected in subpar GDP growth rates). This is a good reminder: “Don’t Fight the Fed.”

We also know that Fed tightening policy will have an impact. History shows that Fed tightening cycles, stock market declines, and recessions tend to coincide—a point to keep in mind given the Fed’s continued plan to raise rates.

Ride out volatility with the appropriate time horizon. 

Over 12-month periods, a traditional balanced portfolio (60% US stocks/40% US core bonds) has fallen as much as 26% and generated returns as high as 48%. However, the range of outcomes narrows as an investor’s time horizon lengthens.

For example, over 20-year periods, the balanced portfolio’s return has ranged from positive 6% annualized at the low end to positive 15% at the high end. But to enjoy those long-term returns, investors must remain disciplined and stay the course during the inevitable pain of shorter-term market drops. Attempting to perfectly time entering and exiting investments is not a successful investment strategy over the long term, as it is nearly impossible to predict what will happen next month, next quarter, or next year. And even if you do get the timing right once and sidestep a large market decline, you have to make another successful timing bet getting back in.

What looks risky could actually be an opportunity.

As we guide our clients through volatile market cycles, one of the messages we reinforce is that these volatile times create opportunities. Volatility allows us to trim asset classes that have gained and use the proceeds to buy asset classes that have declined to more attractive prices, and we can do this through portfolio rebalancing and/or tactical asset allocation.

Each client’s situation is different, so we are careful to consider individual needs and goals when we navigate volatile markets, add new investments, or take advantage of rebalancing opportunities. If you would like to discuss how we would address these market cycles and opportunities in your portfolio, please contact your Litman Gregory Wealth Advisor.

 

Our views and opinions expressed in this report are current as of the date of this report and are subject to change without notice.
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