If we can be sure of anything, most investors hate uncertainty and, as the sentiment grows, markets typically start to pullback. This is nearly common sense, given uncertainty about what is going to happen, many would rather sit on the sidelines and wait until they have more confidence.
You have probably noticed the growing concerns regarding the markets. Most of the uncertainty can be attributed to slowing global growth (especially outside the US) and the Federal Reserve’s choice to start raising rates.
Before diving into current market conditions, growing uncertainty and what to do, it is important that we remember how good the markets have done over the last many years.
Markets Since 2009
The markets are up substantially since bottoming out in 2009 after the financial crisis.
In the chart below, you can see that the US Markets (S&P 500) and overall world markets are up nearly 240% and 118%, respectively. This represents a total annual return of 19.67% and 14.94% which is well above the long term market averages. Bottom line, we have had great markets for nearly 6.5 years.
Source: Morningstar via Kwanti
The biggest fall in the S&P 500 (US Stocks) over this period was in 2011 and was only 18.6%. A downturn is typically not considered a “correction” until it surpasses 20%.
After a period as good as this, you should expect some sort of a correction. If you don’t, you are really just being unrealistic. Everyone knows the markets don’t go up forever.
Markets Since 2007
Unfortunately, it is not all roses and sunshine. Looking at the markets since the peak in 2007 does not look nearly as good. Over this period, the total annualized return for the US markets has only been 5.49%. When we add in the relatively poor performance of international markets, the world markets only annualized a paltry 1.33%.
Source: Morningstar via Kwanti
This is exactly the reason that, while the markets have been up substantially, most people feel like their portfolio has not performed very well.
This highlights a growing concern that developed markets are becoming overvalued and investors should not expect high returns. Conversely, international markets and especially emerging markets, have not enjoyed the same gains which could represent an opportunity going forward.
On December 16th, the Federal Reserve ushered in a new era when they voted to raise short term interest rates for the first time since 2006. While this was expected, as you can see from the above chart, it has not happened for a long time. (You can read more about it here)
Currently, two primary story lines dominate the headlines related to the market selloff:
- The Federal Reserve’s interest rate increases will put downward pressure on a US Economy that is showing some signs of weakness.
- Global Growth (particularly in China) is slowing and there is concern that this will put more downward pressure on markets.
These growth concerns are evidenced by central bank actions abroad. The European equivalent to the FED, the European Central Bank, has chosen to enter a new round of quantitative easing. Due to slowing growth, China has been cutting their interest rate and devaluing their currency.
Leading up to now all the central banks had been easing. There paths have now diverged.
So, what will happen now?
Will international stocks rebound to catch up with the US? Are we about to enter a global recession? Is the FED starting to tighten too soon? Is China headed for a collapse?
All these questions represent uncertainty and there is no doubt that not having a specific answer is uncomfortable.
While the news will have you think that there a lot of inside investors that “know” what is going to happen. For the most part, they are either speculating about the future or commenting on what has already happened.
What should you do?
At times like this it is important for long term investors to embrace the uncertain while keeping an eye on the data.
Unlike the commentators and day traders, we have the time to weather the storm. We are not seeking outlandish returns and remember that the markets have both ups and downs,
Yet, for this to be the case, we have to persevere and recognize that it might be a little uncomfortable.
For our clients, we have not made any changes to our long term target portfolio recommendations. At this point, the markets have not made a move significant enough to necessitate any action. In fact, the US markets are not even below the lows made in August and September.
That said, there are a few actions you should be taking as uncertainty rises:
- Review your portfolio: The best defense against a market downturn is to be properly positioned to begin with. There are numerous studies that demonstrate how difficult it is to time the markets. You should be invested in a portfolio that fits your broader goals and tolerance for risk.
- Check your emotions: How are you feeling about the small pullback that has already occurred? Are you already freaking out about how much your portfolio is down? When markets are up we tend to devalue the investment risks that we are taking on. Now is the time to make sure you handle the investment risks in your portfolio.
- Make sure you are internationally diversified: The US and other developed markets have yet to see a significant downturn. However, some are convincingly arguing that international markets may already be in a bear market. The Reformed Broker did a great write up on this. Valuation metrics are significantly more attractive outside the US.
- Look for tax loss opportunities: As the markets continue to fall, it is important to consider selling investments that have losses. This will help you defer taxes and gain flexibility to make investment changes in the future without significant tax implications.
And lastly, it is always important to remember:
- Uncertainty and market downturns are an expected and reasonable part of the investment process.
- It would be absurd to think that we could always be certain about future expected returns.
- Because our goals are long term, we can weather the storm.