The third quarter of 2015 proved to be a difficult one for investors, as US economic data showed signs of weakness, global slowdown fears persisted and continued talk of looming interest rate hikes all converged, causing equities to tumble both here and abroad.
For the quarter, the S&P was down 6.44%, while the international MSCI EAFE was down 10.19%. Despite the continued chatter of the demise of the bond market, fixed income, as measured by the Barclays US Aggregate Bond, was up 1.23%. So far in October, equities are broadly higher, erasing a meaningful amount of third quarter declines, led by emerging markets, real estate and US large value.
In spite of rising from the depths of the Great Recession with a commensurate bounce back in global equity markets, the historically slow pace of the economic recovery coupled with bouts of market volatility has left many investors weary. This latest round of volatility reminded us of the following excerpt from our October, 2014 commentary after experiencing similar volatility:
It is certainly normal to be concerned when downside volatility presents itself. While no downside move is pleasant, consider the context under which this recent move has taken place. Historically, 5% corrections typically happen a few times a year, a 10% to 15% correction will occur every year or so and, on average, 20% declines happen every 3 to 5 years. As of the end of the quarter, it has been 848 days since the S&P 500 has experienced a 10% correction!
Volatility is the market’s way of reminding us periodically that risk and reward are always related, and that you cannot have one without the other. Prudent long-term investors know that these fluctuations, whatever the cause, are simply the price you pay to get reasonable returns over the long run in line with personal risk tolerance.
During the last financial crisis, when asked about market volatility, Warren Buffet had this to say:
“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” Since Mr. Buffet’s comment and after the recent downturn, the Dow still stands at 16,300. Wise words from one of our country’s most prolific investors.
Interestingly enough, despite third quarter’s volatility, the Dow is now at 17,500!
Most equity markets have recovered from their 2008-2009 lows. Yet, looking back, it is not surprising that this road to market recovery has been a bumpy one, demonstrating the timeless market adage that equities tend to “climb a wall of worry.” We also remain keenly aware of the role behavioral psychology plays in investors’ sentiment and actions as equities ebb and flow along the way. The behavioral fact that investors are giddy and careless when the markets are expensive, while fearful and tentative when markets are inexpensive continues to ring true. And it never ceases to amaze us how quickly investors go from thinking they missed opportunity to lamenting not stepping to the sidelines, as the winds of short-term circumstances sway the market.
Observe the market timeline that shows the success of equities over the long run despite some frightful periods including wars, hurricanes, “stagflation”, and an oil crisis. We are aware that the time period from 2000-2014 has been particularly challenging from a historical perspective, but the markets have seen worse times, and not participating or trying to time these markets would have most likely met with disappointing results.
The lessons learned from successfully climbing this wall of worry can be summarized in these seven basic rules.
We devoted a good portion of our October 2013 commentary on the topic of fixed income. At the time, the Fed had announced their plan to end their quantitative easing program, causing an abrupt spike in interest rates, dubbed the “taper tantrum.” We now find ourselves in the same debate about the role of fixed income in light of the next step in the Fed’s plan to normalize interest rates post the Great Recession. At the crux of these debates is the supposition that fixed income is not viable in times of persistently low or rising interest rates, a general supposition with which we heartily disagree.
For most investors, fixed income is a critical component of a diversified portfolio regardless of interest rate trends because it provides portfolio stability and income in times where the inherent risks of equities present themselves. This is especially relevant for those who are in the distribution phase of their investment lives. With a finite amount of capital from which to draw income, the absence of a fixed income anchor in down markets may result in spending down too much principal, thus causing a vicious cycle where the lower the principal, the higher the yield in potentially dangerous proportions.
While interest rates have been on a general downward trend for years, this trend has certainly not been linear. For example, there have been four periods from 1974-2015 where interest rates have actually been in an uptrend—a period of more than one year with rates rising at least 150bps. So, how did fixed income perform in these time periods?
The results will vary depending upon the mix of the specific fixed income vehicles employed in terms of the length of the maturity period, and whether you are utilizing government or corporate bonds, domestic or international, investment grade or junk, etc. As you know, our philosophy has been to utilize high-quality fixed income securities with maturities limited to five years or less. Research shows that a five-year bond will capture 90 percent of the return of a 30-year bond with less than half the volatility. The following results are reflective of our brand of fixed income investing:
We suspect that the normalization process in interest rates will be orderly and equally non-linear, so we remain confident that we can negotiate through it successfully. In fact, we actually welcome a return to more normalized rates because it will increase the future expected yield on our portfolios. Even if rates remain low for an extended period of time, fixed income vehicles will provide a yield higher than simply leaving it in cash equivalents. More importantly, this “dry powder” gives us the means when appropriate to rebalance accounts by selling appreciated bonds to buy depressed stocks, which serves to shorten our portfolio recovery time in bear markets. Studies demonstrate that in many time periods, a portfolio with a combination of stocks and bonds has had a higher return than one with 100 percent equities, due to this ability to dampen risk and utilize this rebalancing.
If history repeats itself, equities will continue to climb the wall of worry, but over the long run, investors will be handsomely rewarded for the wild ride. As for fixed income, it has been said that the most dependable predictor of future interest rates is current rates because these rates reflect all the market knows at any given time. No one knows the future trend for interest rates, but regardless of their direction, our diversified portfolios are prepared for whatever market conditions present themselves toward meeting your long-term goals.
In light of the inevitable changes in economic trends and government responses, the most certain path to continued personal prosperity is to practice conservative consumption, have a well-crafted plan and have the discipline to stay with it. We remain committed to helping you do so.
1 “How Was Life? Global Well-Being since 1820,” OECD, October 2, 2014. http://www.oecd-ilibrary.org/economics/how-was-life_9789264214262-en.
Investment indices are provided by Standard and Poors, Russell Investments and MSCI. Performance of these indices is not indicative of any particular investment. The indices are unmanaged and individuals cannot invest directly in any index. The Barclays U.S. Aggregate Bond Index is comprised of a variety of taxable bonds, and is used as a measure, or benchmark, of the US bond market. No strategy including diversification can guarantee a profit in a down market. Past performance does not guarantee future results.
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