All Good Things Must Come to an End.
By Jon Aldrich
Just like summer, a riveting novel or a great vacation “All good things must come to an end.” So wrote, the Father of English literature, Geoffrey Chaucer in his poem “Troilus and Criseyde-The Siege of Troy” way back in the 1380’s. So, does this apply to the stock market as well?
Stock markets around the globe have had a very good run since the last significant correction at the beginning of 2016 (Remember that?). At that time, investor fear was very high and there was a worry that the economy was slowing and China was having problems that were going to plunge it into recession and drag the rest of the world with it. There was also concern that as the Federal Reserve was starting to raise interest rates that this would negatively affect stocks. In fact, The S & P 500 dropped more than 10% and small stocks, emerging markets and developed international stocks were down much more than that. Plenty of talking heads on CNBS and other news outlets predicted that the next crash was imminent.
Fast forward to now, June 2017. Besides a minor blip right before the election of Donald Trump last fall, and a couple of sudden one day drops, the stock market has been on an uninterrupted slog higher since last February. Interest rates rose on the 10-year treasury from a low of 1.4% up to 2.5% at yearend (but have now backed off to about 2.2%) with the excitement of Trump being elected and markets thinking his agenda would be pro-growth, tax and stock market friendly, and inflationary. The rise in interest rates did not hurt the appetite for stocks like many had forecast and neither has the fact that President Trump has had about as much success getting his agenda off the ground as the Wile E. Coyote has had in catching the Road Runner. Apparently, getting things accomplished running the country is a tad more difficult than Trump Enterprises.
Stock market volatility as measured by the CBOE VIX index, (also known as the “fear” index) which simply put, is a measure of the expected volatility in the near term, is closing in on record low levels. Generally, extremely low periods of volatility (complacency) are followed by periods of higher volatility and greater fluctuation (both up and down) in stock prices. However, just because this gauge is low does not mean that a market correction is just around the corner. As you can see in the chart of the VIX below, volatility can stay very low for extended periods of time.
Greater volatility on its own is not necessarily a bad thing. Higher volatility can present itself as both greater upside or downside in the markets. Sure, it can mean the odds of a market correction are higher, but it can also mean that a significant rally is imminent as well.
Since market volatility is low, it may mean we are in for a quiet summer, which I have no objection towards. But we should also be aware that the market almost certainly will undergo a correction and possibly a significant correction in the not too distant future. What does this mean? Well, don’t be surprised if the major indices incur a drop of 10% to 20% within the next 12 months or so. A correction is defined as a drop of 10% or more from the highs and a significant correction or bear market is a drop of 20% or more from the highs.
How often do 10% and 20% drops occur in the markets? You may be surprised to know, since we have been spoiled the last few years, according to Ned Davis Research, from 1900 to 2013 there were 123 “corrections” of 10% or greater drops, or about one a year on average. There were also 32 “bear” markets or greater than 20% drops, which nets out to about one every 3.5 years. Hmm. Now let’s look at the maximum drawdowns in the S&P 500 each year going back to 1928:
Did you notice that the worst “selloff” we have had so far in 2017 is only 2.8%? There was only one year (1995) that had less of a drawdown for the year. There is no guarantee that we will have a correction this year, but from looking at this table you must admit the odds definitely favor that we’ll have some type of selloff before too long. However, don’t forget that the numbers above are just the S&P 500. Most investors are diversified into bonds and other assets that would cushion the blow from a downdraft in the S&P 500 so that the numbers would be significantly less than those above. Plus, it is a fool’s errand to try to get into timing market tops and bottoms.
Market corrections are actually a good thing in the longer term. They alleviate some of the excesses and froth that builds up in markets, like relieving pressure in a pressure cooker. They also allow us to rebalance portfolios to take advantage of asset classes with lower prices. If a market goes straight up, the chances of a significant crash can increase. Thus, it is beneficial that there are occasional down periods in markets to reduce the chances of an asset bubble forming. Asset bubbles do not end well. Just ask those chasing the prices of tulips in the 1600’s.
Now is a good time to review your asset allocation and the expected range of outcomes that your current portfolio would likely incur. Over the past few years as markets have been good, people have tended to overestimate their appetite for market risk. Just like they under estimated it in 2008-2009 coming out of the Great Recession. You also have to look at the big picture and even though you may have an allocation to stocks, most of our clients that are drawing funds from their accounts to fund living expenses have a 3 to 5 year “bucket” of investments in short term bonds, cash or CD’s that will not fluctuate much and be there when needed. These funds will be available for living needs whether the longer-term stock portion of the portfolio is up or down. This also allows them to stay invested in stocks for the long haul, since they do not need to sell them when the markets are down to generate cash.
Let’s end all this on a positive note. The chart below shows the returns of the S&P 500 going back to 1950. Out of 67 years, 50 have been positive. Just about 75% of the time! The weatherman or the Cubs would be ecstatic with that type of success rate.