Although we do not yet know how markets will finish 2018, the market volatility investors are currently experiencing has compelled us to reach out now with some high-level thoughts for investors that we will expand upon shortly after year-end.

As of Friday’s market close, the S&P 500 was down 7.87% year-to-date, which is not particularly remarkable for a 12-month return, but investor anxiety has been ignited by a negative 17% return since the market’s Q4 2018 highpoint on October 3rd.¹ The challenge for advisors is how to help investors stay disciplined and invested during the months ahead. We think there are 5 things advisors may want to discuss with their clients to reassure them and to help them keep market events in perspective.

• The market decline will likely extend into early 2019. While it would be nice to be able to tell investors the market is likely to bounce back by the end of 2018, truth-telling tempered with cautious optimism can sometimes be more reassuring to investors. The reality is that we are in the late stage of a secular bull market and much of what we are observing is not surprising in that context: market turbulence, rising rates, slowing earnings growth, low unemployment, and widening credit spreads.
• The 9+ year bull market is likely not yet finished. Having acknowledged that, we should not be surprised by the current market correction, it is not clear that the longer-term bull market is finished. While a bear market is technically defined by a market drop of 20% or more, extended bear markets usually coincide with an economic recession, which we do not currently see on the horizon. The US economy continues to expand, consumer spending is strong, corporate earnings continue to grow, unemployment is remarkably low and likely to fall further, inflation is low and steady, and Fed tightening is measured and cautious. What investors are currently experiencing may be similar to 1994-1995 when the Fed raised rates 300 basis points. During this period price-to-earnings ratios contracted, causing the market to struggle even as earnings continued to grow. Once the Fed reached its target and rate hikes stopped, the markets stabilized and stock prices began to climb. In its announcement of the latest rate hike, the FOMC revised its expectation for further rate hikes in 2019 down, from 3 to 2, and despite the market’s fear of the Fed accidentally triggering a recession, it is not the Fed’s intention to stall economic expansion and any material softening in the prospects for the economy is likely to result in the Fed’s pausing further hikes to stabilize the economy.
• A 15+% drop is not unusual from an historical perspective and investors should not assume it’s the beginning of the end. Drops of more than 15% on average occur roughly every 3 years and have only slightly greater risk of evolving into a loss of 20% or more than it does of recovering. Drops of 15%-20% on average have taken 3.5 months to hit bottom and another 4.7 months to fully recover to its prior peak². Even in this most recent extended rally we have seen a number of corrections that were disheartening in the moment but in hindsight were merely bumps in the road: a 10.2% drop early in 2018, a 14.2% drop that ended in early 2016, a 19.4% drop in 2011 and a 16% drop in 2010.
• Politics dominate the headlines but earnings drive the market. There is no shortage of news in the U.S. that individually or cumulatively might saddle investors with pessimism. Fear of war, criminal investigations surrounding the US President, policy uncertainty, and a partial government shutdown can certainly contribute to market volatility in the short term, but the more substantive drivers of the market’s correction are the fading impact of the tax and spending stimulus relative to 2018, the potential impact of a trade war with China on US corporate earnings, and fears that the Fed is tightening money supply too quickly. The growth rate of earnings is indeed slowing, but they are still growing. A slower growth rate for earnings and higher (though still not restrictive) interest rates can justify a lower multiple but this does not mean that the market won’t regain its footing and continue to advance on the basis of growth in earnings with continued help from corporate stock buybacks which are expected to be 22% higher than the record amount in 2018.³ Finally, while the risk to earnings of a trade war with the world’s second largest economy, China, are real, the economic consequences that are already being felt places enormous political pressure on both Presidents Trump and Xi to ultimately come to some agreement.
• Diversification in client portfolios is now more important than ever. A change in market dynamics is likely to be accompanied by a change in market leadership. What has done well in the past may very well struggle in the period ahead. The diversification message is sometimes dismissed by investors in periods such as this year when every major asset class suffered a negative return.⁴ But the reality is that sometimes the benefit of diversification is holding asset classes or strategies that lost less than investors would have experienced in an all large-cap US equity portfolio. With lower correlation among stocks, active managers may finally have the opportunity to outperform index managers. Select international stock markets may finally outperform US stocks as the headwind of a strengthening dollar weakens. With widening credit spreads, municipal bonds may become attractive for reasons other than tax-free income. The environment going forward may present attractive opportunities to strategists who can selectively invest globally for enhanced return and may cause high-yield strategies that have in the past handily outperformed investment-grade debt to struggle. Advisors with clients who are overly anxious about the gyrations in the value of their portfolio may want to revisit that client’s risk tolerance given that realized market volatility is, at the moment, not that far above the market’s long-term average. This may be particularly important for clients in distribution mode if they are systemically making distributions from equity portfolios, increasing the difficulty of bouncing back when the market eventually recovers. Consistent with these thoughts on diversification, some of our strategists are tactically reducing their equity exposure to limit losses, with an eye to methodically adding equity exposure back once they see signals that suggest the market has regained its footing.

Best wishes for a healthy, happy, and prosperous New Year.

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