Volatility in context

Position your clients for success in today’s market.

After a relatively benign 2017 with regard to big moves in the market, investors could be forgiven for thinking this stability may be a “new normal.” If anything, now is the time to remind your clients that volatility could make a comeback in 2018, and that it may not be a bad thing. 

When it comes to stock market movements, context is everything. The media can fan the flames of panic, such as the headlines in February trumpeting the worst point decline in the history of the Dow Jones Industrial Average (down 1,600 points on February 5). But in percentage terms, the drop wasn’t in the top 20 historical worst market declines, and the markets rebounded the very next day.¹

What about a market correction?

“A correction wouldn’t be unwelcome,” says Philip Petursson, Chief Investment Strategist at Manulife Investments. He explains that a correction can be healthy for the markets: “The good news is as long as economic growth remains on track, if earnings growth remains steady and strong, then you will tend to see a recovery. But sometimes the market, like a rubber band, can get stretched. If it gets stretched too much to the upside, it’ll snap back. So, often you want some volatility, you want the checks and balances. A nice, healthy correction, akin to what we’ve seen historically, is on average approximately 13 per cent over the course of a year.”

A correction can do a couple of things. First, it can help mitigate the fallout from assets that have become overheated as a result of speculation. A little volatility in the markets can make investors rethink the fundamentals of their investments. If this doesn’t happen, assets can become highly inflated trading on pure speculation, as happened in the dot-com bubble and before the stock market crash of 1987. A little volatility can provide a “gut check” for investors and encourage caution by proving that what goes up, may not always go up.

Second, a correction can bring investors who have been holding cash back into the market. Although sitting on the sidelines is never recommended, institutional investors such as portfolio managers may have a “buy target” on a stock, and when it pulls back they may execute a large trade. These big institutional investors buying stock at their target prices can contribute to a rebound from the initial drop. Likewise, some investors may “buy the dip,” adding money into the market and contributing to the recovery.

The impact of rising volatility in today’s market 

Volatility has been subdued since the first quarter of 2016. The S&P 500 Index didn’t experience a pullback above 3 per cent in 2017, but volatility returned with a vengeance at the beginning of February 2018, with the index falling close to 10 per cent in 10 days. What was even more impressive was the subsequent rally, which saw the S&P 500 recover close to 50 per cent of its losses over a five-day period. While the speed of the recovery was surprising, the upward movement was not. 

When a pullback occurs, history shows that investors are well served by taking advantage of the volatility – if it occurs in a non-recessionary period. Since 1970, there have been 40 corrections (defined as a drop of more than 10 per cent from the previous peak). We looked at the three-, six-, and 12-month forward returns of an investment made at 10 per cent below the prior peak. On average, investors were rewarded with a return of 10 per cent after one year. In 15 of the 40 instances the one-year return was negative, with approximately 90 per cent of those occurring either prior to or during a recession. Investing is a probability-based decision, and volatility can provide an opportunity for investors. 

But what about a recession?

Petursson doesn’t think a recession is likely, because a number of inflationary indicators are evident in today’s environment. “We are starting to see signs that inflation will move higher through this year on multiple fronts. We’ve seen commodity price inflation over the last year and a half, and producer price inputs move higher, so input costs for manufacturers have gone up. We haven’t seen it on the wages side, but there seems to be a consensus that it’s imminent,” says Petursson. 

Also, some of the typical signs of a recession are notably absent. Petursson says, “What we are experiencing is a valuation adjustment to rising inflation expectations. Once we are through this, the equity markets should refocus on the strong earnings growth and strong economic growth that we expect to continue through the year.” But that in itself will contribute to higher volatility through 2018. “We stand by our belief that equity markets will deliver a positive return for investors in 2018; however, the journey will be more volatile than last year,” Petursson concludes. 

How can advisors help clients?

Volatility reinforces two things: the benefits of asset allocation and the importance of keeping clients focused on their individual investment goals. 

The first and most important thing to do is to rebalance portfolios. Take profits from one area and rebalance back to the asset allocation for which the portfolio has been designed to meet its long-term objectives. Review your clients’ portfolios. Given the excellent year U.S. equities had in 2017, there may be an opportunity to rebalance them. Philip Petursson recommends looking at international equities: “So in combination with attractive valuation, attractive economic fundamentals, we also have attractive earnings growth … And for the first time in a number of years what we are starting to recommend is to perhaps take some profits in the United States, reduce what [may be] an overweight position to the U.S. and add that to international [equities]. Or make your international equity component an overweight from neutral.”

The next step is to have a conversation with clients who have forgotten what volatility feels like or are perhaps experiencing it for the first time. Remind them of their long-term strategy, and encourage them to stay the course and not get caught up in the mania of bitcoin or cannabis companies or whatever the euphoria of the day might be. Be the positive influence for your clients. During times of volatility, sticking to their plan and staying disciplined in the fundamentals of investing will help increase the probability of achieving their investment goals. And reminding your clients why they started investing in the first place will strengthen the relationship and trust between you.

The best defence is a well-balanced portfolio

One mistake some investors make in response to volatility is going to cash. This tends to be the wrong decision because it’s often based on emotion and poorly timed. Sometimes when markets do see a drop, investors can be reluctant to buy back at the low price. This was seen between 2008 and 2012, when investors sold at the bottom and did not come back into the equity markets with any real force until the S&P 500 fully recovered at the end of 2012. Sitting on the sidelines is never recommended, nor is trying to time the market. 

“The art and science is to have a portfolio positioned for the current market but ready to pounce on opportunities as they come forward. We are not recommending an outright sell of U.S. equities, but to take advantage of the exceptional markets we have enjoyed and take the profits earned over the last number of years and deploy them into new opportunities such as Europe. Basically, shift [your new allocations] from U.S. to the international market,” says Petursson. For more information on International Equities check out the Market Intelligence Report on AdvisorCafe.