Broker Check
Making Sense of Market Volatility

Making Sense of Market Volatility

| November 02, 2018

With the last two weeks’ volatility in stock prices, you may be wondering if the market is about to plunge and if you should rethink your investment strategy.
While sharing insights about the current state of the economy and the markets can be helpful to clients, it's important to remind investors we are monitoring the markets while providing reassuring perspective on what is happening.

Making sense of what’s happening

  • Let's take a step back and remind you of some of the basics about markets and investing that advisors and other investment professionals probably take for granted.
  • The moves we’ve seen recently in the Dow Jones Industrial Average (the Dow) sound bigger than they really are. For example, the 831 point drop in the Dow two weeks ago conjured up memories from when the Dow dropped 778 points in one day in September 2008. Investors were appropriately alarmed at the time given that the move represented an overnight 7% loss in value. However, rising stock prices over the last 9 years mean that same point drop is only 3.15% today, a still large but not extraordinary one day drop for the stock market.1
  • The decline is likely short-lived. We’ve seen an unusually high percentage of days with negative returns over the last few weeks. While historically this has been followed by negative returns in the near term, returns three, six, and twelve-months later have been positive more often than negative.
  • A stock market decline of 10% is not unusual or unexpected. The S&P 500 closed last week down 9.28% from its peak on September 20th and at one point was down a little over 10% -- effectively erasing almost all of its gains from the first three quarters of the year. Nevertheless, a peak to trough drop of 10% or more has historically occurred on average every 1.5 years. A drop of 10% or more has occurred at least once in seven of the last 10 calendar years including, most recently, the first quarter of this year. Investor expectations for the market can frequently get ahead of a longer term sustainable growth rate and the market can drop 10% or more without any material change in the economy or the long-term outlook for the stock market.
  • What’s happened this year is not out of character for a mid-term election year. While no one knows with certainty what will happen next, market forecasters often look to history for patterns that may be relevant to today. The fact that the U.S. has a mid-term election coming up -- the results of which are uncertain given that the outcome will hinge primarily on each party’s ability to turn out its base -- cannot be ignored. Mid-term election years have historically been the worst year in the presidential cycle, struggling for the first three quarters but bouncing back in the fourth after the election has been decided. While the timing of the market’s moves this year may be off the historical norm by a few weeks, the year is hardly paving new ground. The good news about mid-term election years is that twelve months after the election the US stock market historically has delivered a positive return.
  • The economy in the third quarter of this year grew by 3.5% which is slower than the prior quarter but by no means slow. Although investors may point to news about housing starts or the growth in money supply or some other indicator as supporting their concern that the market rally is finished, the reality is that there is no single economic indicator that is a reliable signal for the market’s future direction and, even if there were, no indicator has been “negative” for a period long enough to clearly signal a long-term shift in market momentum rather than what has turned out in the past to be a short-lived pause or reversal before the market resumed its long-term rally. Admittedly, market forecasts can be at odds with economic forecasts because the stock market is composed of investors speculating about the future of the economy. Recessions tend not to happen overnight. In total, the US economy still looks healthy.

Reasons for optimism

Although there are one-off indicators that an investor may point to in support of their anxiety that the market rally is finished, the reality is, it is too soon to know with any confidence; and for the moment there is still cause for optimism.

  • The recent drop in the US stock market has made valuations more attractive with the current forward lookingprice-to- earnings multiple of 15.5 versus the 5-year average of 16.4.2
  • The single largest buyer of US equities has been US corporate issuers buying back their own stock. The value of stock buybacks announced in 2018 but not yet executed should provide some support for the market in the coming months.
  • To the extent that investor anxiety is fueled by concerns about rising rates, the Fed’s rate hikes are not pre-programmed, and it retains the ability to slow or pause rate increases if economic growth slows too dramatically, or if there is risk of a recession.
  • Based on historical market drops, the magnitude (<10%) and duration (39 days) of the current market decline makes it more likely to bounce back than to continue declining.
  • Recessions do not happen overnight and although economic growth in the third quarter was slower than the prior quarter, it still grew at a respectable rate of 3.5%.3

What if we’re wrong?
It is impossible to manage money for any length of time without being humbled by the market’s tendency to sometimes do the unexpected. For this reason, strategists, like financial advisors, tend to structure portfolios for clients so that the implications of being wrong are not disastrous. Again, this is something that advisors may take for granted but may find it reassuring to be reminded that if the stock market fails to recover or continues to decline. The downside risk of the client’s portfolio has – by design – been structured to be tolerable. Several insights that might reassure you include:

  • Even if stocks continued to decline and entered bear market territory, the decline would still likely be short-lived because a recession does not appear to be imminent. An historical analysis of bear markets (declines of 20% or more) recently published by Ned Davis Research suggests that bear market declines that don’t occur along with a recession have a median decline of 23% over seven months whereas bear markets that overlap with an economic recession are likely to be much deeper and prolonged.
  • Even in the event of a bear market decline in the value of stocks, the impact to the client’s portfolio is likely to be muted by the client’s allocation to bonds or other diversifying strategies, and any decline in value is likely to be recovered over time.
  • The potential for market declines and dramatic shifts in the leadership of market sectors is why many advisors include an allocation to one or more tactical strategies that can move in and out of the overall market or specific market sectors.

Suggestions for what to do

While it may seem unhelpful to counsel investors to remain calm, the bottom line is that we don’t yet have enough information to know whether the current market dip will continue downward and turn into a bear market or if once the mid-term elections are decided and corporate issuers resume their stock buy-back activity, the rally is likely to continue. In either event we expect to know more within a month or so. Based on the information available today, our advice to clients would be to maintain their current asset allocation strategy, or adjust it minimally, unless and until we see multiple signals supporting the likelihood of a recession or continued price declines. Historically the damage to investors’ finances is greatest as a result of being out of the market than from riding out even the deepest decline.
We recognize no one can listen to the recent market news without feeling a pang of anxiety about their personal finances. However, we are monitoring events so that you don't have to. At this point we are not recommending any major changes across portfolios, modest at best. These are times in which diversification and having a disciplined behavior are important.
Please feel free to call or email us to discuss anything that is on your mind.


1 Source: FactSet
2 Ibid
3 Wall Street Journal, U.S. Economy Grew at 3.5% Rate in Third Quarter, October 26, 2018