Stock Market Volatility in PerspectiveSubmitted by Affiance Financial on November 5th, 2018
We believe the stock market’s 10% decline from the September 20th high is due to a confluence of three major fears for investors. First is the fear of rising interest rates and the Federal Reserve Bank’s monetary policy. Second is the fear of slower corporate earnings growth. Third is the fear of trade wars, especially with China. We believe that recent stock market weakness reflects temporary risks and is NOT a precursor to deeper economic problems.
It is both stressful and upsetting when portfolios have negative returns. Our natural instinct is to flee the danger. “Sell the losers and buy the winners” (i.e. sell low and buy high). It is at these times that we believe it helps to take a step back and look at the current situation through a longer lens.
Stock market draw-downs of some magnitude take place every year (see chart). Stock market draw-downs of 10% or more are considered “corrections” and are a normal part of the stock market cycle. A smaller 5% to 10 % dip in stock prices should be expected two to three times a year on average, while a correction of 10% or more should be expected at least once per year. In fact, having more than one correction in any given year would not be unusual. Larger drops of 20% or more happen about every one and a half years on average.
The problem is that when the “average” is based on a relatively small sample size with a relatively wide variance, every event (even one that is mathematically average) can seem exceptional. The last significant stock market decline after the great recession ending in 2009 was when the S&P 500 index fell by 17% during October of 2011. Clearly, the long and smooth ride the U.S. stock market has provided investors during the past seven years has been far from average. Averages aside, periods of falling stock prices can be unnerving to investors who commonly wonder if the decline will be short lived and rebound, or if stock prices will continue to plunge lower.
We are not market timers and we know that while it appears attractive, attempting to time the stock market is a fool’s folly — attempted by many, accomplished by few, and relished by all. Aside from the very real issues of capital gains taxes and transaction costs, market timing requires being right not once but twice — both when selling and when buying back into the market. We cannot predict when a correction or bear market may occur, but we can make sure clients are prepared for volatility with a portfolio asset allocation that correctly reflects their risk tolerance and capacity. In addition, by using a smart money philosophy — making sure there is always a good place to take money from if needed — we can help clients weather market declines.
Stock market declines need to be considered in the context of the current economic cycle, political and fiscal environment, as well as macroeconomic events. There is no one-size-fits-all approach to a market decline, and each situation needs to be evaluated independently. The biggest question to address when faced with a market decline is whether or not we are in a correction that may be connected with a recession or accompanied by broader systematic risks. Today, we do not believe this to be the case. We believe that the current economic expansion remains intact with most, if not all, leading indicators still showing positive and/or record results. The country’s major banking and financial institutions are well-capitalized and generally well managed. Inflation is modest and unemployment is near lows last reached 50 years ago in the late 1960s. In other words, people are working and have money to spend. We would note that the unemployment rate remained below 4% for nearly four years from 1966 to 1970. So, low employment and modest GDP growth could be the norm for an extended period of time.
Today, we do not plan to make any changes to portfolios based on current market conditions, but we continue to watch for signs that may lead us to a different conclusion. If markets move more significantly, or become more volatile, we will weigh the risk of re-balancing portfolios with the risk of being whipsawed as the stock market rebounds from a temporary drop. If you have any questions, or would like to discuss your personal situation, please contact your financial advisor today.