The following answers a few questions on the recent market volatility:
Why is the market volatile?
Despite what some glib ‘talking heads’ on CNBC and other news channels will have you believe, nobody knows for sure. However, there are several economic and geopolitical events that are spooking the markets. To name a few- rising interest rates, fears that the economy will start slowing and descend into a recession, trade wars with China and uncertainty surrounding Brexit. Considering that the markets have rallied for more than 9 years, during which it has almost quadrupled since the lows set in March 2009, it should come as no surprise that these events would adversely affect the markets.
How does the recent volatility compare with historical volatility?
While the recent market movement may seem unusual, what was unusual was the uninterrupted rally that preceded it, especially in 2017. Over the long run on average, the stock market has had intraday moves of 2% or more 41 times a year, has fallen by 2% or more 5 times a year and has fallen by 14% at least once a year. There has been a lot of talk recently about market corrections (Defined as a drop of more than 10%)- of the last 20 corrections only 4 eventually ended in a bear market (Defined as stocks falling more than 20%) and 3 of those occurred during recessions (In 1980, 2000 and 2007).
So, is there a recession coming?
Again, nobody can predict the exact timing of a recession. However, I do follow the economy and pay close attention to certain factors that sometimes anticipate a recession and none of them are flashing red yet. Economic growth and corporate earnings (The latter being more relevant for stocks) are moderating for sure. There has been a lot of chatter on TV networks about peak earnings (Much like the old peak oil theory that nobody talks about anymore) but what the ‘talking heads’ mean is peak earnings growth. Considering how strong growth has been in recent quarters, fueled by tax cuts, monetary stimulus and perhaps deregulation, some moderation in growth is to be expected. Moderation in earnings growth has not been followed by a bear market historically. In the last 11 peaks in earnings growth, 10 have been followed by positive equity returns with average returns of 18% over 12 months. The Federal reserve has been increasing interest rates and historically this has led to a recession, but they have recently indicated that they may slow the pace of interest rate hikes.
Why can’t you sell everything and get back into the market after the recession?
This is a topic on which I have spent a considerable amount of time. As I discussed in our 2Q 2017 newsletter , the opportunity cost of waiting for a crash to invest is high. Waiting for the market to fall 10 to 50% before investing would historically have led to a worse absolute and relative return versus a buy and hold strategy. The result is not very different if you were to sell everything one year before the start of a bear market and get in one year afterwards- you would have lost 5% on average by doing this. This is because markets go up more than they go down and they exhibit a tremendous amount of momentum which lasts longer when the markets are rising and especially towards the end of the bull market.
I believe a better approach than trying to time the market is to construct well diversified portfolios of superior investment products, matching client risk profiles i.e. the willingness to tolerate volatility and individual liquidity situation. A globally diversified portfolio gives one the confidence to invest through recessions and bear markets. Over the long run this approach can add value as it is more about the time in the market than timing the market.