It’s not a secret that market volatility has picked up significantly in 2022 with corrections being seen across major indices. The S&P 500 is down -18% from its January 3 peak. A brutal sell-off in tech sent the NASDAQ down -29% from its November 19 high. Compounding the pain seen in equity markets, U.S. aggregate bonds have dropped nearly -10%.
So what’s driving this volatility? The war in Ukraine is causing surging commodity prices. COVID lockdowns in China are exacerbating strained supply chains. Inflation is at forty-year highs prompting the Fed to aggressively tighten monetary policy. Together, these dynamics are also creating uncertainty about future growth. However, it’s important to highlight that the U.S. consumer has been resilient, the labor market is strong, profits are still growing, and now valuations have reset. Given all of that, how do investors navigate this type of market volatility? Here are several key principles to bear in mind:
Volatility is normal. A booming consumer, robust profits, and ample fiscal and monetary accommodation drove a 27% gain in the S&P 500 in 2021 with only a -5% drawdown during the year. Yet the S&P 500 falls -14% on average each year, so 2021 was far from normal while this year is in line with historical drawdowns. Ultimately, annual returns have been positive in 32 out of the last 42 years, underscoring the need for patience.
Diversification supports portfolios through market downturns. If you had invested in the equity market at its October 2007 peak, it would have taken you until March 2012 to recover your initial investment. However, if you had invested in a 60/40 stock/bond portfolio instead, your portfolio would have recovered in October 2010 – a year and a half earlier. Diversification captures returns on the upside and protects on the downside to deliver better risk-adjusted returns.
It’s about time in the markets… Being invested in the equity market for any one calendar year since 1950 could have yielded a 47% return or a -39% return. However, over longer time periods the range of outcomes is compressed significantly and overwhelmingly skews positive, particularly if diversified with bond exposure. A 50/50 diversified stock/bond portfolio did not experience a period of negative returns over the rolling 5, 10, or 20-year calendar periods since 1950.
…not timing the markets. Investors are often tempted to get out when markets get choppy. However, if an investor were to miss the 10 best days in the market rather than staying fully invested, they would have cut their return in half from 9.5% to 5.3% annualized over the last 20 years. What is the chance of missing the 10 best days? Seven of the 10 best days occurred within two weeks of the 10 worst days, often immediately following the worst days. Exiting on a bad day means potentially missing the rebound.
Stay invested when you feel the worst. Sentiment is not a great guide for investor behavior. Looking at the peaks and troughs of consumer sentiment since 1970, average one-year equity returns following peaks in consumer sentiment were 4.1%, but average returns following the bottoms in sentiment were 24.9%. As seen in the chart below, recent sentiment has reached levels not seen since 2011 and 2008 levels.
Take into consideration one more crucial point: through multiple wars, recessions, pandemics, and crises, the S&P 500 has never failed to regain a prior peak— and then surpass it. The best strategy during volatile times is to maintain composure and stick to your investment plan. Amid the current talk about recession fears, it’s important to note that markets will usually bottom out prior to an actual recession (as defined by two consecutive quarters of negative GDP). As seen in the chart below, usually the damage to equity markets is priced in six to twelve months before an actual recession hits.
Furthermore, since WWII the median drawdown during recessions has been 24% on the S&P 500. Our current drawdown of 18% is nearing that median. While the equity markets may be pricing in a 70% chance of recession, most analysts still put the odds of a recession at around 30%.
Overall, the economy is actually in fairly good shape. Monetary policy is getting tighter, but not overly so. Valuations are now at 10-year averages, and investors’ extreme negative mood is proving to be a contrarian indicator, revealing a market that is actually quite bullish. While recent moves in the market have been a roller coaster, our long-term view hasn’t changed. During the drawdowns we have seen thus far we’ve made significant moves to portfolios, adjusting a handful of individual holdings and rebalancing allocations as valuations become more reasonable. We will continue to monitor and modify portfolios as conditions change and may increase equity exposure if multiples reach historically low levels in the face of the challenges presented above. As we monitor inflation, we know it may get worse and cause more volatility in the near term. But we are expecting inflation to abate, the signs of which are already appearing.
Denver Private Wealth Management is an independent fee-based financial planning practice with 50+ years of experience in the financial industry. DWPM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at firstname.lastname@example.org.
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