Perhaps the most talked about and least understood concepts in investing is the riskiness of stocks. This is particularly true in periods where stocks are relatively stable and positive, as they were in 2016 and 2017. However, stock market participants should also expect periodic bouts of volatility, and the last 6 months provide an excellent example of this volatility in practice. This newsletter will address stock market volatility, including a discussion of what took place in markets over the prior two quarters and what this means in context. Additionally, we will provide an outlook for 2019 and beyond, and how we believe investors should incorporate future expectations into their portfolios.
The fourth quarter of 2018 was a challenging one for stock markets, with the S&P 500 falling about 13.5%. International stocks did not fare much better, losing 11.5% over the quarter. Based solely on financial headlines, investors could not be blamed for believing that the world was in the midst of financial meltdown, or at the very least an unusually bad market. The truth was somewhat less dire, particularly when viewed in a longer-term context. Since 1926, US stocks have had quarterly moves of 10% or greater 94 times, or approximately 25% of all calendar quarters. Quarterly moves of more than 15% are not unheard of, having taken place about 10% of all quarters. While this does not make the fourth quarter performance more enjoyable for investors, it is somewhat comforting to recognize that the market turbulence was not a statistical outlier.
Perhaps more importantly, the period of October through December doesn’t tell the whole story for 2018. Through the first 9 months, US stocks rose 10.6%. Thus, even given the year-end selloff, the S&P 500 was only down by 4.4% for the year. As a reminder, in any given year stock performance can range from down 20% to up 40% without that year being outside of statistical norms. While long-term stock market performance tends to revert to a small range (up between 9% and 14% per year), the performance in a single year can be quite volatile.
Market volatility is also not one-sided. The decline in the fourth quarter was matched by a rebound in the first quarter of 2019, as US stocks rebounded 13.6% through the end of March. Investors who stuck with the market through the 6 months from October 2018 through the end of March 2019 would have a loss of 1.7%. Extending that period back an additional 6 months, the S&P 500 realized a 1-year return of 9.5%. Selling out of equities at the end of December (perhaps with the intention of avoiding larger losses) would have caused an investor to miss the market rebound, and to lock in the losses received in the fourth quarter. The emotional aspects of investing can often times be the most difficult to manage. This is why Empirical maintains focus on statistical data. Understanding expected ranges of returns can help investors prepare for volatile market stretches, and to stick to their plan even when the emotional response might incline them to do otherwise.
Another prevalent theme in financial media is the potential for an economic recession on the horizon. The typical basis for downturn concerns is the length of the current bull market. Pundits theorize that the current economic expansion has lasted so long (117 months and counting), that the US must be due for a recession. Stagnant European growth and Brexit concerns, trade tensions between the US and China, and political polarization around the world are cited as potential contributors to an economic slowdown as well. Economic turbulence could be relevant for investors as a recession would generally be expected to correspond with a bear market in stocks.
The current US expansion is now the second longest since 1900, and will become the longest if it continues through July. However, unlike many previous cycles, growth has been quite subdued over this period. The US economy has expanded at a rate of 2.3% per year, which is well under the 2.7% average of the last 50 years (including recessions). Slower growth has had the effect of somewhat muting many of the excesses that tend to accompany rapidly growing economies. Examples of these excesses, such as loosening credit standards, inflated market valuations, increased investor leverage, and a general underestimation of market risks, have not been much in evidence during this expansion. Credit standards, while less stringent than directly after the Financial Crisis, are nowhere near the excesses seen in the leadup to 2007. Government debt has increased substantially over the past decade, but consumer household debt is about 18% lower than the peak in 2007, and corporate debt levels are relatively low in a historical sense as well.
Perhaps most important is the absence of market euphoria that characterizes the leadup to many prior recessions and bear markets. Investor sentiment is less bullish than the 30-year average, and market valuations are within normal ranges using metrics like price-to-book and price-to-earnings. While inflated valuations are not necessary for a market pullback, they certainly increase the probability of a bear market in the near term.
This is not to say that there are no risks to global growth. Overly aggressive monetary tightening by the Federal Reserve has contributed to recessions in the past. Brexit looms as a risk to the European Union experiment, and the hapless British government seems no closer to a solution than they were at the time of the vote to leave the European Union in 2016. The rise of nationalism and isolationist policies around the world could lead to an increase in trade conflicts, which would almost certainly have a negative effect on growth. While none of these risks appears to be an imminent threat, neither should they be wholly discounted.
Implications for Investors
While debating the future of the global economy may make for interesting conversation, the more immediate concern for investors is what might be the potential implications for their portfolios. A look at historical data gives a counterintuitive result – economic performance is not necessarily linked with concurrent market performance. A number of studies have shown that the GDP growth rate of a country has little relation to the performance of stocks in the country, and last year offers a good example of this phenomenon. In the US, economic growth was the strongest since 2010, and unemployment numbers hit their lowest rates in nearly 50 years. Yet despite this, stocks ended the year down over 4%, which is the worst performance since 2008, in the midst of the Financial Crisis. Conversely, even if economic growth does slow over the next year or two, it does not necessarily imply that markets will be negative as well. In fact, in 67% of calendar years where US GDP growth was negative, S&P 500 returns were positive.
The point of this is not to foretell economic or stock market performance for the upcoming year or two, but rather to emphasize the unpredictability of stock performance in the short run. As mentioned above, stocks can oscillate quite strongly in any given 12-month period. A well-designed investment strategy does not try to achieve success through the impossible task of predicting the future, but instead builds a portfolio structured to mitigate unnecessary risk while managing risk that is unavoidable. For example, systematic rebalancing can help an investor capture more returns in a volatile environment.
In December and January, after markets had fallen, Empirical portfolio managers undertook a number of actions to capitalize on potential opportunities, including aggressive tax-loss harvesting, strategic Roth conversions, and a general rebalancing of portfolios from bonds into stocks, as many investors were below their targeted allocation to stocks as a result of the market decline. As stock markets have rebounded, portfolio managers have been rebalancing portfolios back to a neutral position, often from stocks back to bonds. By simply following a predetermined rebalancing strategy, portfolios will naturally buy low and sell high, without any need to predict the future. It is important to remember that a strategy that you cannot hold to in turbulent markets is not the correct strategy for you, regardless of potential returns. If you have any questions about what steps Empirical takes to manage portfolio risk, please contact your advisor.
This newsletter is distributed for informational purposes only and nothing herein constitutes an offer to sell or a solicitation of an offer to buy any security and nothing herein should be construed as such. All investment strategies and investments involve risk of loss, including the possible loss of all amounts invested, and nothing herein should be construed as a guarantee of any specific outcome or profit. While we have gathered the information presented herein from sources that we believe to be reliable, we cannot guarantee the accuracy or completeness of the information presented and the information presented should not be relied upon as such. Any opinions expressed herein are our opinions and are current only as of the date of distribution, and are subject to change without notice. We disclaim any obligation to provide revised opinions in the event of changed circumstances.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.
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 All S&P 500 index data provided by the Dimensional Returns Program
 As represented by the MSCI All-Country World ex-US Index
 In the context of this article, US stocks will always refer to the S&P 500 Index
 In this context, long term refers to rolling 30 year returns on the S&P 500 index since 1970
 As measured by the Federal Reserve’s Financial Obligation Ratio: https://www.federalreserve.gov/releases/housedebt/default.htm
 Source: JPMorgan Guide to the Markets Q2 2019