Stocks and bonds have been extremely volatile impacted by inflationary conditions, increasing interest rates and geopolitics. What makes the market volatility worse is that bonds, which are usually the defensive part of the portfolio have had the worst ever start to a year. Bonds have declined 10% this year not far from the -17.5% that US stocks have suffered. Usually, stocks and bonds move in opposite directions and bonds perform the role of ‘disaster insurance’ with positive performance when there is stress in the economy and/or the equity markets.
Why have financial markets been volatile?
Economic conditions are uncertain and expected to be so for a while. Supply chain problems exacerbated by covid lockdowns in China and the unending war in Ukraine have led to a scarcity of goods, while demand has been strong as most of the world reopens post pandemic. The consumer price index increased 8.5% over the last year, the highest rate in over 40 years. There are some signs that inflation is moderating from those levels but is expected to be elevated for a while.
The Federal Reserve (Fed) increased interest rates by another 50 basis points (100 basis points is 1%) in May and is expected to continue increasing rates through the year to combat inflation. The fear here is that in its attempt to subdue inflation, the Fed may cause a recession. Another fear is that the Fed’s actions may cause a recession without reducing inflation, a condition dubbed as stagflation, an especially painful condition for people and the financial markets. As of now, there are no signs of an impending recession –for eg. employment numbers and consumer spending, which are a significant portion of the US GDP are strong. The yield curve has ‘un-inverted’ and is now steep. (Please refer to the first quarter market newsletter here for an explanation of the yield curve as a signal of recession)
How does the current volatility compare to the past?
As mentioned previously, the magnitude of decline in bonds is unprecedented. However, with this decline, bonds have become relatively cheap and its role as ‘disaster insurance’ has become stronger. Earlier in the year, when bond prices were high, there were doubts it could perform this role.
Fig 1: Stocks decline 14% on average every year, sometimes more sometimes less
| The decline in stocks is well within its historical range. Stocks decline 14% on average every year and have declined more, especially during a recession. Even in the last 10 years, when stocks have almost tripled, there were significant declines along the way. Figures 1 and 2 show the historical pullbacks in stocks. Fig 2: There were significant declines in the last 10 years as the stock market almost tripled |
 Source: Morningstar What should investors do? The volatility that we are experiencing in the financial markets is what risk in investments is all about. Risk is not bad per se, if you are compensated for taking the risk. Investment volatility is the price you pay for long term returns. The higher the volatility, the higher the expected return which is why stocks have higher long term returns than bonds. However, to reduce the probability of permanent loss of capital, a risk that is never compensated, adequate diversification is required. The best course of action is to stay invested in a portfolio that is appropriately constructed based on your objectives such as risk tolerance and income needs. As a (rather dramatic) illustration of the benefits of this long-term approach, if you had (unfortunately) invested $100,000 every time the stock market was at an all-time high, just before a steep decline i.e in 1973, 1987, 1999, 2007 and 2020, you would (still) have had almost $6 million today. Pullbacks can be a good opportunity to add to your investments if your investment horizon is long enough. There are also other financial planning opportunities such as a Roth conversion if you are expected to be in a low tax bracket. When markets are down you may also have opportunities for tax loss harvesting and/or rebalancing. Why should investors not sell in anticipation of further declines? During times of market stress, there is a temptation to sell especially, if the ‘forecast’ is for further declines. However, it is impossible to forecast the economy or the markets correctly and repeatedly. As the joke goes, economists have correctly forecasted 9 of the last 6 recessions. Besides, to make a meaningful difference, you must be right twice, once when you sell and once when you buy back. Also, the financial markets and the economy do not always move in lockstep, often markets anticipate inflexion points in the economy well in advance, making the task of forecasting the stock market based on the economy a very unreliable exercise. A more reliable way to invest for the long term is to create a robust, diversified portfolio with several sources of returns and hold it for the long term. |