Sharp Setback in Risk Assets
Markets have experienced a sharp sell-off in recent weeks, pushing year-to-date returns for many asset classes into negative territory. The primary reasons for recent weakness may be attributed to the following factors:
1. China growth concerns. China is the worlds second largest economy and is in the middle of downshifting and rebalancing economic growth away from export dependency toward more balanced, higher quality growth comprised of increased domestic consumption.
2. Disappointing earnings amid higher valuations. Earnings for the S&P 500 have flatlined over the past year at a time when price/earnings multiples are at the upper end of historical ranges.
3. Federal Reserve desire to raise interest rates. The Fed has maintained an extraordinary policy stance since 2008, with short-term rates at 0% and periodic asset purchases (known as quantitative easing). With employment conditions returning to normal, the Fed is trying to slowly return its policy stance to normal, which is creating stress at different points in the global markets.
4. A supply-driven collapse in crude oil prices below $40 has caused increased stress on the energy sector. Energy is the worst performing sector in the S&P 500 during 2015, down -20%. Falling oil prices are pressuring earnings, lower-quality balance sheets, and dividends in the sector.
Areas hardest hit in the sell-off have included emerging markets, energy, commodities, high yield, and aggressive growth stocks. Within the fixed income markets, high yield bonds have struggled, declining 4% since the end of May. On the equity front, emerging markets are down -24% from the April 2015 highs and 37% from the March 2011 highs. Prices for this asset class are now at the same levels as they were in 2006! Similarly, commodities and the energy sector have fallen in unison with both areas impacted by a collapse in oil prices. We have also seen the froth come off some previous high-momentum stocks that had dominated market returns up until recently. Companies such as Disney (-19% from highs), Gilead (-14% from highs), and Apple (-20% from highs), which were among a handful of stocks accounting for all of the markets gain in 2015, have seen meaningful corrections.
Keeping a Proper Perspective of the Market Sell-off
Correction was long overdue. Investors should not be surprised that we are seeing a correction in prices. The current bull market has been the third longest in history without a 10% or 20% correction. Heading into this week, the S&P 500 had gone 914 days without declining 10% or more from the highs, compared to a historical average of 161 days. Furthermore, the S&P 500 has advanced 1,563 days without declining 20% or more, compared to a historical average of 635 days. We have been overdue for increased volatility.
Not uncommon to see intra-year weakness, particularly at this time of the year. The chart below illustrates annual returns for the S&P 500 since 1980. The index has produced average annual returns of 10% per year and has risen in 27 of 34 years despite intra-year declines that have averaged 14%. The third quarter has also proven a seasonally weak period for the markets.
Some of the best return potential lies in areas being hardest hit by the sell-off.
Equity holdings within portfolios are bearing the brunt of selling pressure. Keep in mind, however, these are your long-term assets dedicated for future needs, often 10 years and beyond. Cash and fixed income investments are included in allocations for diversification purposes, liquidity, and to meet intermediate-term spending needs. These are also the investments within portfolios today that have the least attractive long-term return prospects. Based upon the current yields of the bond market, investors should expect annualized returns of roughly 2.3% annually for core fixed income over the next decade, before taxes and inflation. This is a relatively low bar for riskier assets like stocks to surpass, especially over a 10 year period when dividend yields today are higher than government bond yields. Viewing assets from a proper time horizon perspective can help avoid mistakes during periods of market stress.
World-class managers employed in client portfolios have an attention to risk and can exploit opportunity.
The benefits of employing world-class managers often surfaces during periods of higher volatility. First, an attention to risk can provide downside protection during bear markets market setbacks. We have seen this firsthand in the current sell-off from funds such as Tweedy Browne Global Value, FPA Crescent, American Mutual, Templeton Foreign, Royce Premier, Wells Fargo Absolute Return Fund, American Century Equity Income and others. While these managers have not escaped losses, their returns have surpassed those of many peers and broad market indices.
Secondly, volatility should allow world-class managers to exploit opportunities created by market fear and depressed prices.These managers closely watch their investment universe, seeking to identify businesses and securities that become attractively priced relative to long-term potential.
Remain diversified. Dont try to time the market.
Markets are inherently difficult to predict. Over and over again, we have seen attempts to time the market prove futile and mostly lead to failure. Timing the market requires two successful decisions, both of which are naturally influenced by emotion: (1) determining the right time to sell and (2) determining the right time to buy back in. Few investors get both correct! We find that investors have a tendency to sell too late, then fail to buy back in time to capture the strong rebounds that occur after sharp market declines in essence capturing most of the declines then missing much of the rebound. We recommend clients do not deviate from an asset allocation consistent with their long-term goals and objectives out of fear of further market losses.
The markets were overdue for a setback. It is difficult to predict where the current sell-off will bottom or how long it will last. However, it is not uncommon for the equity markets to see sharp intra-year declines and still produce solid long-term results. Even though equities are bearing the brunt of the sell-off, the asset class should play a critical role in future portfolio returns
given the unusually low interest rate environment. As a result, we recommend clients stay diversified, avoid attempts to time the markets, and be on the lookout for opportunities that inevitably arise from market dislocations. Employing world class managers can play a key role in identifying such opportunities.