The Search for Silver Linings

It can be hard staying positive amid what can seem like an onslaught of negative news. Whether it's the stock market, politics of the day, or even the horrible tragedy in Pittsburgh this past weekend, finding the silver lining can seem like searching for a needle in a haystack.

Through yesterday this has been the 8th worst October for stocks since 1928, with the S&P 500 down almost 10% and the Dow down about 9%. 1929 and 1987 both saw 20+% declines in October, while '08 saw a 17% drop. So, I guess the silver lining is that it can always be worse?

All sectors of the stock market have been getting hammered so far in October except for Consumer Staples and Utilities, more conservative sectors deemed too boring to grow much during the runup in stock prices. More exciting sectors, such as Technology, posted most of the gains earlier in the year but have been taking it on the chin as investors take profits.

Developed foreign markets (such as Europe) and emerging markets (such as China) are each down about 10% this month, with Germany and China in a technical "bear market" by falling at least 20% from recent highs.

The American Association of Individual Investors tracks investor sentiment. "Bullishness" has unsurprisingly taken a nose dive this month as investors have been spooked by recent market volatility. The current reading is well below average and indicative of investors who were perhaps rudely awakened to the fact that markets go up and down.

Is there anything positive to report as we near month's end? Bonds are finally showing some life. Still down this year and down a fraction for the month, bond prices were up last week as stocks fell. Gold is also up. Both asset classes demonstrate the risk aversion alluded to in the AAII sentiment survey.

How long will this volatility continue? The talking heads on TV can drone on and on about their predictions but truthfully, nobody knows. While major economic indicators aren't signaling an imminent recession, the stock market may get worse before it gets better.

Corporate earnings are solid but guidance from companies about future earnings is trending softer. Interest rates are still historically low, but the Federal Reserve may continue raising rates even as growth in the economy slows. Due to recent stock market volatility, some investors anticipate the Fed will hold off raising rates but once more this year and maybe not at all next year. Should the Fed continue raising rates it would likely lead to more market volatility even as the economy grows.

For me, in times of market stress it's helpful to fall back on the investing fundamentals of controlling quality, cost, allocation, and rebalancing. While these might sound obvious, they can be hard to do when markets get noisy. And there sure is a lot of noise.

This week I'm attaching another article from Jim Parker at Dimensional Funds about seven simple truths to investing. You may note that none of these deal with innovative ways to find the next hot stock or can't-lose mutual fund. Instead, they're mostly about building knowledge and dealing with the psychological aspects of investing. Nail those and the rest is a cake walk.

Volatility is back. Just as many people were starting to think markets only ever move in one direction, the pendulum has swung the other way. Anxiety is a completely natural response to these events. Acting on those emotions, though, can end up doing us more harm than good.

There are a number of tidy-sounding theories about why markets have become more volatile. Among the issues frequently splashed across newspaper front pages: global growth fears, policy uncertainty, geopolitical risk, and even the Ebola virus.

In many cases, these issues are not new. The US Federal Reserve gave notice last year it was contemplating its exit from quantitative easing (an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective). Much of Europe has been struggling with sluggish growth or recession for years, and there are always geopolitical tensions somewhere.

In some ways, the increase in volatility in recent weeks could be just as much a reflection of the fact that volatility has been very low for some time. Investors in aggregate were satisfied earlier this year with a low price on risk, but now they are applying a higher discount rate to risky assets.

So, the increase in market volatility is an expression of uncertainty. Markets do not move in one direction. If they did, there would be no return from investing in stocks and bonds. And if volatility remained low forever, there would probably be more reason to worry.

As to what happens next, no one knows for sure. That is the nature of risk. In the meantime, investors can help manage their risk by diversifying broadly across and within asset classes. We have seen the benefit of that in recent weeks as bonds have rallied strongly.

For those still anxious, here are seven simple truths to help you live with volatility:

1. Don't make presumptions.
Remember that markets are unpredictable and do not always react the way the experts predict they will. When central banks relaxed monetary policy during the crisis of 2008-09, many analysts warned of an inflation breakout. If anything, the reverse has been the case with central banks fretting about deflation.

2. Someone is buying.
Quitting the equity market when prices are falling is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.

3. Market timing is hard.
Recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was at its worst—the S&P 500 turned and put in seven consecutive months of gains totaling almost 80%. This is not to predict that a similarly vertically shaped recovery is in the cards, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

4. Never forget the power of diversification.
While equity markets have turned rocky again, highly rated government bonds have flourished. This helps limit the damage to balanced fund investors. So, diversification spreads risk and can lessen the bumps in the road.

5. Markets and economies are different things.
The world economy is forever changing, and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector but good for consumers. New economic forces are emerging as global measures of poverty, education, and health improve. A recent OECD study shows how far the world has come in the past 200 years.

6. Nothing lasts forever.
Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

7. Discipline is rewarded.
The market volatility is worrisome, no doubt. The feelings being generated are completely understandable and familiar to those who have seen this before. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.

Have questions? Ask me. I can help.