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Fourth Quarter 2018 Newsletter

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Current Market Volatility In Perspective

After reaching an all-time market high on September 21st, the S&P 500 entered a bear market (20% decline) in late December, falling to levels last reached in early 2017.  Having experienced positive returns through September, the S&P was down just over 4% for the year.  All other domestic and international equity asset classes had greater full year losses.  Declines of this magnitude naturally cause one to wonder what the future holds and if they should make changes to their portfolios. While it may be difficult to remain calm during a substantial market decline, it is important to remember that volatility is a regular part of investing in stocks.  As a client of DHG Wealth Advisors, you’ve likely been invested through one of the five declines over 10% for the S&P 500 that we’ve experienced since 2008. The biggest, which was a 19% drop at the end of 2011, saw a recovery in just 5 months - although many take longer than that to recover.

More recently, we experienced historical lows in volatility in 2017 with the S&P returning 19% with the largest market drop for the year being 3% between peak to trough.  We outlined this in more detail in our 1Q 2018 Quarterly Newsletter “Finally, Finally”, noting that volatility was likely to remain elevated off these lows, in line with historical norms.   For long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the drawdown itself, making temporary losses permanent.   Often the intention is to get back into the market at a later date.   That often happens after the market has recovered some of its losses, erasing the value of the original sale.  

Intra-Year Declines

Exhibit 1 shows calendar year returns for the US stock market since 1979, as well as the largest intra-year declines that occurred during a given year. During this period, the average intra-year decline was about 14%. About half of the years observed had declines of more than 10%, and around a third had declines of more than 15%. Despite substantial intra-year drops, calendar year returns were positive in 29 years out of the 38 examined. This goes to show just how common market declines are and how difficult it is to say whether a large intra-year decline will result in negative returns over the entire year.

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Reacting Impacts Performance

If one were to try and time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance? If current market prices aggregate the information and expectations of market participants, stock mispricing cannot be systematically exploited through market timing. In other words, it is unlikely that investors can successfully time the market, and if they do manage it, it may be a result of luck rather than skill. Further complicating the prospect of market timing being additive to portfolio performance is the fact that a substantial proportion of the total return of stocks over long periods comes from just a handful of days. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, the prudent course is likely to remain invested during periods of volatility rather than jump in and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.

Exhibit 2 helps illustrate this point. It shows the annualized compound return of the S&P 500 Index going back to 1990 and illustrates the impact of missing out on just a few days of strong returns. The bars represent the hypothetical growth of $1,000 over the period and show what happened if you missed the best single day during the period and what happened if you missed a handful of the best single days. The data shows that being on the sidelines for only a few of the best single days in the market would have resulted in substantially lower returns than the total period had to offer.

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Exhibit 3:  Note that market declines of over 10% are common, and have occurred once or twice each year in the US Market since 1926.  Declines of over 20% have occurred less frequently, about every 2 to 3 years.  However, in each case, the market has rewarded patient investors with solid annualized returns over subsequent periods. 

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Conclusion

While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful. By adhering to a well-thought-out investment plan, ideally agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty.

[Thanks to Bill Laird, advisor from our Jacksonville office and valuable member of our Investment Policy Committee, for gathering, researching and assimilating the above information.]

Fourth Quarter 2018 Asset Class Returns

4Q18Returns

Global stock markets plunged in the 4th quarter, turning the previous 9 months of solid returns into an annual loss for virtually all equity asset classes.  Most suffered meaningful double digit returns for the quarter.  For the year, Large Cap US stocks fared the best, with middle single digit losses, while most other equity asset classes, domestic and international, suffered 10% to 20% losses. Domestic equities performed relatively better than their International counterparts in 2018, which was a switch from 2017, when International lead the way with 25% to 35% annual returns.   Yields on all bond maturities contracted, which produced small gains for the quarter.  Nonetheless, both intermediate and long term bonds lost money during the full year. 

There were many purported reasons for the equity selloff.  The expected late December increase by the Federal Reserve added insult to injury by announcing they expected to have two more increases in 2019.  It wasn’t the actual rate moves, but the expected economic slowdown they would potentially hasten, that was probably the biggest reason quoted as causing the panicky selling.   In addition, earlier optimism regarding potential trade agreements with China seemed to be fading quickly, with no recent positive communications between the two countries at the time of the market swoon. 

As usual, the volatility of the market pullbacks were quite opposite to the gradual increases we experienced last year. Hence the expression, “the market goes up like an escalator and down like an elevator.” The most popular current question is, “What Now?”  Much of the market fear has to do with future events, such as continuing increases in interest rates, coming recessions, trade wars etc.  But clearly there is no guarantee that any of those events will take place. 

What we do know is that projected 2019 earnings look healthy, although not matching the nearly 30% earnings growth the S&P 500 experienced in 2018.  In addition, inflation is still at a very moderate rate and shows no signs of dramatic increase in 2019, and the high market valuations that caused trepidation over the last couple of years have disappeared.  In fact, by most methods, the current US stock valuation is average or even below average compared to the last 25 years of measurement.  See below.

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Note that nearly all of the valuation methods show the year-end S&P 500 price as being modestly undervalued, and any further movement down only increases that undervaluation.  No one has a crystal ball to determine future events, but with the observable facts we have now, sellers of equities appear ready to assume only the worst possible outcome for many of the above described events. 

Long term investors should look at the current environment as a favorable time to rebalance into equities, or add new money into stocks, rather than reacting otherwise.  Time has shown that although difficult, discipline during market drops is absolutely necessary to assure your well thought out investment plan does not succumb to the short term fear.    This fear is often inflamed by fame seeking talking heads or internet articles written to elicit as many clicks as possible. 

After nearly a decade of positive market performance, it is completely natural for the type of market pullback we are currently experiencing.  It is part of a long term investing cycle, and is the reason why equities enjoy a superior long term return compared to less volatile asset classes. 

This New Year promises to bring more clarity to many of the topics discussed above.  While we eagerly await that information, remember that investment cycles, like seasons of the year, are natural and should be expected.  Stay warm during the cold months, and don’t allow the winds of volatility to put a chill in your enjoyment of the long term process of responsibly growing your portfolio.  Enjoy your winter!

Sincerely,

ricksig

Frederick F. Kramer IV, JD
Co-Chief Investment Officer


The content in this newsletter is for informational purposes only and does not constitute investment advice or an offer to buy or sell any security. The information in this newsletter is believed to be accurate as of the time it is distributed and may become inaccurate or outdated with the passage of time. You should contact your financial advisor or CPA professional before making any tax or investment-related decision.  Past performance does not guarantee future results.  All investments may lose money.

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  1. 4Q18InvestmentNewsletter.pdf 1/10/2019 11:22:40 AM