09/09/2020
ALTERNATIVES CHANNEL
Record Highs and Sharp Declines. Now What?
by SPECIAL TO ETF TRENDS on SEPTEMBER 6, 2020
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In August, the S&P 500 index passed its pre-pandemic record high, marking the second-fastest bear market recovery in history. While the gains are certainly welcomed by investors, the straight-up rebound has raised a number of questions and makes pullbacks even more jarring.
1. If the economy is doing poorly, why has the stock market recovered so quickly?
Markets are forward-looking –Economic data tends to review backward-looking activity. Stocks on the other hand should reflect future expectations – whether those expectations are right or wrong. Yes, the economy is still a long way from regaining its pre-pandemic level of output and profit. But current market pricing reflects investor expectations for an uninterrupted economic recovery and rebound in corporate profits through 2021.
Policy matters – Fiscal and monetary stimulus has been a key support for the economy and the 55% rise in stock prices since the market low. Spending from Congress has, so far, filled the loss of income created by the historic spike in unemployment. For the first time in history, national income went up during a recession, rather than down. Consumer spending has been incredibly resilient. At the same time, the Federal Reserve (Fed) has implemented unprecedented monetary policy stimulus, which has both ensured the stability of the financial system and pushed investors to take more risk in search of reward.
2. After such a historic run, what’s next?
With risk assets on a tear, clients’ fears of missing out and advisors’ fears of meaningfully underperforming is palpable. While there is a bullish case to be made, there are also reasons for caution and oftentimes a sharp pullback can be an important reminder.
The market’s anticipation of an economic and corporate profit rebound is appropriate, but has it gone too far? Current valuations and nearly euphoric measures of trading sentiment signal, to us at least, that investors may be a little ahead of themselves. As in previous economic shocks, we expect pullbacks on the way to recovery.
There are a number of things for investors to be worried about: the recovery is likely to be uneven, temporary job loss is turning permanent in some sectors, and political and geopolitical risks abound. And so, while there is always risk to investing, high valuations and profound uncertainty make the next 6-12 months particularly worrisome.
It’s important to remember that pullbacks are normal. Looking at the last 15 bull-market recoveries over the past 90 years, the average return in the first year was 47%. But it’s not smooth sailing; 5% and 10% pullbacks are common. Most recently, the recovery from 2009 had three 5% pullbacks in the first year and a more than 15% correction in the summer of 2010 slightly after the initial one-year period studied. We don’t expect the bull market to unwind, but we wouldn’t be surprised to see markets take new precedent moving forward.
Pullbacks are expected
Bear Market Bottom Gain in first year of rebound Number of 5% Pullbacks in 1st Year Number of 10% Pullbacks in 1st Year
6/1/1932 121% 1 5
3/14/1935 77% 3 0
3/31/1938 29% 2 5
4/28/1942 54% 1 0
5/19/1947 19% 3 0
6/13/1949 42% 0 1
10/22/1957 31% 1 0
6/26/1962 33% 1 1
10/7/1966 33% 2 0
5/26/1970 44% 1 1
10/3/1974 38% 2 2
8/12/1982 58% 3 0
12/4/1987 21% 5 0
10/9/2002 34% 3 1
3/9/2009 69% 3 0
3/23/2020 54% 1 0
Average excluding 2020 47% 2.1 1.1
Bear Markets are defined as a 20% decline from a high. Recovery dates begin as of the date of the bear market recovery, and are only definable with the benefit of hindsight. Drawdowns are defined as a 5% or 10% pull back from a local high. 10% pull backs are excluded from 5% pullbacks in this scenario. The S&P 500 index is comprised of the 500 largest companies in the U.S. stock market. Past performance is no guarantee of future results, which will vary.
3. How can an investor put new money to work?
The decision to invest today is certainly dependent on market conditions, but it is also dependent on an investor’s goals and circumstances. For example, a client with a long investment horizon will likely have a higher risk tolerance and allocate to different assets than a client with a shorter time horizon – all else equal.
Dollar cost averaging is one way to spread risk during an investor’s accumulation phase. By taking a portion of cash inflows (income) and putting it to work at regular intervals, an investor can avoid the temptation of timing the market.
For investors with a large portion of wealth in cash and no new significant cash flows on the horizon, a careful investment strategy may be more prudent. In these cases, relying exclusively on dollar cost averaging to enter an investment strategy can generate a large cash drag on overall returns. In this case, a DCA strategy is more akin to market timing.
Given our near-term market concerns, there are three potential ways an investor can enter the market anew: (1) invest with a lower risk allocation than current strategic asset profile (i.e. more bonds or lower volatility investment strategies, income focused strategies); (2) enter the strategy with a portion of the lump sum and hold some cash like assets for tactical opportunities as they arise; or (3) Invest with an active manager who can take small tactical bets based on their perception of the market.
Bottom line
Financial markets have rallied significantly supported by policy, stronger than expected reopening data, and big-tech optimism. However, a new record high stock does not eliminate the economic risk following the biggest health emergency in 100 years. Given high levels of uncertainty, it is vital for investors to remain patient and stick to their strategic goals.
Despite the recent setback, a record rally in stocks has likely contributed to significant portfolio drift. Investors should consider portfolio rebalancing to correct for that. Investors could also consider building a cash position to take advantage of market opportunities, broadening sector and asset class exposure moving beyond Large Cap US technology stocks, and adjusting expectations for future market returns.
Working with a financial professional can help you stay focused on an investment strategy that can help you reach your long-term financial goals in all types of market (and political) environments.
