By Schwab Center for Financial Research
Markets have been unusually volatile so far, with plunging oil prices, slowing growth in China, steep declines in overseas equity markets, fragility in the high-yield bond market and concerns about the Federal Reserve all contributing to uncertainty.
While we have experienced a 10% U.S. stock market correction twice in the past year — and some pockets of the equity market (for instance, the NASDAQ) have done worse — we do not expect the current correction to turn into a broad-based bear market.
Investors should review their portfolios to make sure they still reflect their target asset allocations and goals. They should also resist the urge to buy and sell based solely on recent market movements, as it could hobble their performance over time.
Global stocks have dipped into bear-market territory, as signs of a slowing Chinese economy, worries over European banks and tumbling commodity prices revived fears about weak global growth. The U.S. market has had the worst start ever to a calendar year.
Understandably, investors often become nervous when markets are volatile, and we are hearing many questions from clients. Here are some of the most frequent ones, and our perspective:
What will it take to calm the markets?
Markets don’t like uncertainty, and there are a number of unknowns hanging over investors right now. For example: When will oil prices stabilize, and at what level? How quickly and by how much will the Chinese economy slow, and what impact will that have on other countries’ economies? What’s the outlook for the U.S. economy? Will we see heavy defaults by less-creditworthy companies? How will central banks react to global conditions? Will the Federal Reserve move too quickly, too slowly or just right in raising interest rates? Until these issues are resolved, we expect elevated volatility to continue.
Are we headed into a recession?
Economic forecasting is an imperfect exercise, but based on recent economic data, we don’t believe either the global or U.S. economies will fall into recession, although the risks have increased.
In the U.S., we continue to see economic growth thanks to a healthy labor market, housing investment, more government spending and a strong services sector. While there are meaningful pockets of weakness in the real economy (for example, manufacturing) and market-based indicators (such as yield spreads, the shape of the yield curve and stock prices) are currently painting a dour picture, the bulk of the leading economic indicators are not at danger levels at the present time.
Globally, we see continued growth in Europe (for example, purchasing manager index levels are consistent with expanding economies, eurozone leading economic indicators on the rise) and a modest deceleration in China, while other indicators are at levels associated with a low probability of global recession.
Will the correction in U.S. stocks turn into a bear market?
We maintain a neutral view and expect bouts of volatility and corrections to continue. By “neutral” we mean that investors should maintain an investment in stocks consistent with their appetite for risk and investing goals.
This view is driven by a few factors. First, if we’re right about the economy, we expect the recent price drops will ultimately reflect a correction, not a longer-term bear market. Severe bear markets rarely happen without recessions.
Second, stock prices typically exhibit rich valuations just before big price drops, but valuations for U.S. equities are generally below historical median levels. However, we don’t see valuations expanding until earnings growth returns.
Finally, the U.S. market does not appear full of “hot money” — that is, funds moved around rapidly by investors seeking short-term profit — waiting to be pulled out of the market.
Are we experiencing a repeat of the 2008-early 2009 market drop?
There are more differences than similarities between today and 2008, so we don’t believe it’s an apt comparison. It’s true that the 2008-09 crisis started with the bursting of the U.S. housing bubble, leading to the failure of financial institutions. Credit issues are again affecting many of the world’s financial companies. However, the leverage and derivatives that magnified the problems then are far less present today. The global banking system is much stronger, which means there’s less concern right now about the solvency of the broader banking system.
In the last few days investors have focused on the European banking system, and there are a variety of genuine concerns there (such as weak net interest margin due to negative interest rates, slow loan growth and a worsening credit quality outlook). None of this is new, but markets appear to be more worried about a heightened risk of a financial crisis or a large European bank facing a liquidity squeeze. There are, however, many backstops in place to provide support as needed (for example, better capitalization and European Central Bank crisis programs).
The better comparison in our mind (at this stage) would be with 1997-1998, when a round of Asian currency devaluations was triggered by Fed rate hike that exposed trade and budget vulnerabilities in Asian emerging market economies. That led to a regional crisis, a huge spike in global asset class volatility, and even a near-cyclical bear market in U.S. stocks (the S&P 500 Index was down 19% peak-to-trough during that episode) — but it did not crash global growth or markets generally.
What is the outlook for interest rates?
Bond market participants, in general, believe odds have dropped substantially that the Federal Reserve will raise interest rates multiple times in 2016. We believe the most likely scenario is that the Fed will raise rates once, at most, in 2016 due to market turmoil.
What should I do right now?
Every investor is different, but here are a few steps that everyone should consider, in our opinion.
Rebalance your portfolio as needed. Rebalancing is the act of selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight. It’s a good idea to do this periodically because market changes can skew your allocation — over time, assets that have risen in value will account for more of your portfolio, while those that have fallen will account for less. If you aren’t sure how to do this for your portfolio, speak to a Schwab professional. The benefit of rebalancing is that it helps to keep your portfolio at a risk level that is consistent with your goals, potentially improving your returns over time as the market continues to change. Few investors enjoy volatility, but more volatile markets can increase the value of rebalancing.
Understand what you own and map it to your goals. A cardinal sin of investing is taking on risks that don’t make sense — or no longer make sense — given your situation and life stage. If you haven’t looked at your portfolio recently to make sure you understand what each security and asset class is doing, now is an especially good time to become reacquainted with it. If you expect to spend from your portfolio within the next few years, consider holding assets that historically have been relatively liquid and less volatile than stocks, such as cash and short-term bonds. This can help you avoid having to sell in a down market.
Resist the urge to buy or sell based solely on recent market movements. Successful investing is about the future, not the past. Our company and others have studied the behavior of investors in equity mutual funds, and compared individual investors’ returns to the returns of the funds themselves. In general, investors’ returns lagged the funds’ returns, largely because of herd mentality. Individual investors tend to jump in after the fund has done well and flee after it has underperformed. This doesn’t mean one should hold on blindly to declining investments, but it’s a good idea to take into account the investment’s future prospects and the role it plays in your portfolio.
Know what you can stomach. Over the long term, a more aggressive allocation has historically reaped higher rewards in terms of returns, but there’s a dark side. Aggressive allocations have historically had a much wider range of returns. Investors achieve those higher returns through “stick-to-itiveness.” Many investors have learned the hard way that their tolerance for a big loss in the short term was less than they thought. A conservative allocation’s lower historical returns have generally come with significantly less drawdown (that is, price decline from a peak) and volatility. For some, it’s worth the lower expected return. But the reality is that many investors want all of the upside when markets are performing well — but none of the downside when they are not. That is highly unrealistic.
If you don’t have a target asset allocation, get one. We periodically discuss asset classes (for example, stocks or bonds) and whether we believe investors should be overweight or underweight the asset class relative to a target allocation. That kind of advice isn’t much help if you don’t have a target. Many investors don’t — but they should, as that is where strategic investing begins. In the course of setting a target, you’ll be forced to think about what amount of risk you’re comfortable with emotionally, how much risk you can afford to take, and when you expect to need the money for your goals, such as retirement spending or a child’s college education.
Adapt your trading to fast-moving markets. If you are entering trades, keep in mind that your approach to entering orders should take into account current conditions.
Bouts of market volatility are a normal, if sometimes unnerving, feature of long-term investing. As we consistently tell investors, the best way to weather the storm is to take the long view, select a portfolio that makes sense for your situation, stick to your plan and remember that this too shall pass.
Lawton Retirement Plan Consultants, LLC (LRPC’s) Monday Morning Minute is crafted to provide decision-maker’s with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.
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This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.
Additional Important Disclosures
Source: Bloomberg. Based on difference between S&P 500 Index closing level of 1,186.75 on 7/17/1998 and closing level of 957.28 on 8/31/1998. A bear market is often defined as a 20% decline from a peak. A cyclical bear market is usually short-lived; there can be multiple cyclical bear markets within a secular (or longer-term) bear market. Asset allocation strategies do not ensure a profit and do not protect against losses in declining markets. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance. The S&P 500 Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events will be created that may increase your tax liability. Rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment.