2018 was a year most investors would like to forget. Losses across asset classes were widespread. What's noteworthy is that 90% of asset classes posted negative returns - an event that hasn't occurred in recent history (note "Under Pressure" chart below). Diversification across different types of stocks wasn't incredibly effective in reducing losses, but asset allocation (or broadly speaking the amount of assets one invests in each stocks and bonds) was.
When stock market volatility spikes and markets begin to capitulate, we’re sometimes asked whether it’s time to get out of stocks altogether. Firstly, it’s incredibly difficult to tell what will happen in the stock market over short periods of time. Over the long run we know stocks will perform well, albeit with bouts of volatility. In fact, most of us will own stock in some percentage for the rest of our lives. This is largely because of our need to hedge against a rise in prices (inflation) and maintain purchasing power over time. Instead of questioning whether or not to own stocks, investors should consider how much of your portfolio should be in stocks.
Through analysis which considers spending, tolerance for risk, assets, time horizon, and a growth assumption, one can mathematically solve for how much stock to maintain in a portfolio over time.
Let’s decipher this equation using an analogy. One can compare the amount of stock in a portfolio to how much fuel to pump into an airplane before a flight. As a passenger, you probably want to make sure your plane has enough fuel to make it to your destination for a safe landing. Upon hitting turbulence half way through your flight, you’re probably not going to voluntarily put on a parachute and exit the plane at 30,000 feet.
In investing, investors must determine the right amount of stock to own to reach their goals and although turbulence (volatility) is uncomfortable, the best way to reach your destination is to stick with a predetermined plan.
For those that have longer time horizons and are going to be saving towards their retirement goals for years to come, volatility shouldn’t matter. Not to say that market capitulation won’t be concerning at times, but even considering big losses in the markets, stocks will recover and then some given adequate time.
If you have 5-10 years, take some comfort that stocks will recover after an intial swoon. If you have fewer than 5 years, revisiting your allocation to stocks and bonds should be a priority.
For those that are either retired, or retiring imminently, appropriate allocations to stocks are more critical. Retirement portfolios can have a wide range of allocation to stocks depending on the amount of assets that have been accumulated and the need to grow those assets over time to support spending needs. However, when markets retreat, it’s important for retirees who cannot simply live off of portfolio income, to have a basket of safe assets (bonds and cash) to spend down while equities recover.
What We Are Watching
So where does the market stand with regards to how cheap stocks are based on the recent pull back?
Well, stocks have become cheaper – global valuations are below their 25-year averages across the major asset classes (chart, right side). This doesn’t mean stocks can’t get even cheaper, but they do offer a much more attractive value than a year ago. In order for stocks to remain "cheap", however, earnings must hold their value. A recent retreat in global earnings is worth keeping an eye on (chart, left side).
Don’t give up on diversification – U.S. stocks have become less expensive of late, but international stocks are still much cheaper. This doesn't mean put all your stocks in one foreign basket, but rather serve as a reminder to not exclude investments that haven't been the best performers. We believe a globally diversified portfolio is better positioned for total returns moving forward.
Manufacturing has begun to soften, but leading economic indicators still point to an expanding U.S. economy.
Market expectations for interest rates have been revised downward, as have the estimates from the Federal Open Markets Committee. This is an encouraging sign which reflects a more flexible Federal Reserve. According to Powell, "We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate." 1 A more measured response the the Federal Reserve that approximates market expectations could help provide stability.
Unemployment remains at historic lows, a sign of the continued health of our domestic economy. Wages are rising, which supports consumer spending, but wages aren’t rising so strongly as to negatively impact corporate earnings at this point.
While we don't see a recession on the immediate horizon, one will come at some point. Many investors don't want to hear the "R" word, but we all must acknowledge that economic cycles do come to an end and we should set our expectations accordingly. If investors prepare a plan ahead of time and revisit the plan annually, they can navigate volatile times to reach their destination. What we do know is that stocks have gotten cheaper and portfolios need to be rebalanced accordingly.
*Diversification can help reduce risk but it cannot eliminate the risk of investment losses.