much ado about volatility

The markets have become volatile once again, as concerns about China's economy add to fears of a global economic slowdown. Add to that volatility in oil prices, changes in the relative strength of currencies, and expectations that the U.S. Federal Reserve will gradually raise interest rates, and the result is uncertainty in the markets.

“Nothing causes investors to question their strategy and worry about their money like dramatic moves in the markets,” says John Sweeney, Fidelity executive vice president of retirement income and investment strategies. “A natural reaction to that fear might be to reduce or eliminate any exposure to stocks, thinking it will stem further losses and calm your fears, but that may not make sense in the long run.”


In fact, what seemed like some of the worst times to get into the market turned out to be the best times. The best five-year return in the U.S. stock market began in May 1932—in the midst of the Great Depression. The next best five-year period began in July 1982 amid an economy in the midst of one of the worst recessions in the post-war period, featuring double-digit levels of unemployment and interest rates.

withdrawing in retirement

We did the math—looking at history and simulating many potential outcomes—and landed on this guideline: Aim to withdraw no more than 4%–5% from your savings each year to be confident you can enjoy your someday through 20–30 years of retirement.

We went back and looked at what would have happened with a hypothetical person’s 28-year retirement, basing our calculations on the first day of each month, beginning with January 1, 1926. In 90% of those retirement periods, a balanced portfolio (50% stocks, 40% bonds, and 10% cash) with a 4% withdrawal rate would have lasted for at least 32 years, and a 5% withdrawal rate would have lasted for at least 22 years. This means that even with market ups and downs, these withdrawal amounts worked most of the time—assuming the investors stuck to this balanced investment plan.

panic is not a strategy

RANDY: You know, in these times it seems like short-term volatility, it’s very difficult to be an investor and let your emotions—you know, keep your emotions out of it. So people always get sort of hung up on these short-term moves, they get kind of panicked or something like that. What are some of the things that we always remind our investors to keep in mind during these trying times?

LIZ ANN: Well, it’s funny, we have this dog-eared report that I initially wrote back in 2008, during the heart of the financial crisis, called "Panic is Not a Strategy." And, unfortunately, we’ve had to edit it and dust it off a few times since then, most recently until now, back in August. And I think a lot of the tenets of that hold true, which is if you think about it, and use just August as an example. If during that mini flash crash you had, if you just panicked and sold everything, you would have missed the huge rally on the upside again in October. There’s no way to perfectly time the exit and the entry, which suggests to investors you need to ride through it. The key point is having discipline. Make sure you have a plan. That plan should be relevant to you as an investor, your time horizon and your risk tolerance. And then stick with that plan, which often involves rebalancing. So when you do get big moves in the market, your portfolio then tells you maybe you ought to do something. Which, more often than not is going to mean you’re adding to asset classes that maybe are underperforming, and that kind of keeps you on the right side of things. Ultimately, though, diversification, and that discipline around it, is going to help you ride through some of these more difficult periods of time—like the one we’re in right now.

-- Randy Frederick and Liz Ann Sonders

worst ten-day starts

The S&P 500 is down 8% since the year began, the worst two-week start to a year ever. There have only been five other years since 1928 when the index fell by more than 5% in the first 10 trading days of the year. As shown in the B.I.G. table below, looking back at the five worst yearly starts, the returns for the rest of January were mixed, while the rest of year returns were more positive (dramatically so in three cases). The only dud was during the financial crisis in 2008.

Source: Bespoke Investment Group (B.I.G.).

The correction has similarities to last August’s—a swift price decline for a market that had recently been near multi-year highs. SentimenTrader (ST) notes it’s quite rare to see this kind of severity relatively soon after trading near a three-year high—and the fact that we’re seeing another episode so close to last August’s is also rare. Looking at history, there was a binary outcome after such periods: the market tended to worsen looking ahead if a recession had already begun or was imminent. But if there was no recession, the market did decidedly better.

Recession?

Every predictive recession model I have studied still suggests a low risk of recession. In fact, if we are in one or heading toward one, it would be the first time in history the leading indicators did not roll over and provide ample warning.

buying the face of pessimism

There’s a story about Templeton that offers a good starting point for our discussion on buying in the face of pessimism (from an article by Charles Sizemore – link):

“The late Sir John Templeton had a great strategy for managing volatility and taking his emotions out of the equation. He would make a list of stocks that he would love to own if only they sold for a substantially cheaper price. He would then place limit orders to buy them at those prices. If a wave of panic swept the market, Sir John would not be paralyzed by indecision because the decision had already been made for him.”

That last phrase – the decision had already been made for him – really strikes a chord with me.

2016? Don't get your hopes up

The most important indicator of the stock market valuation is what we called Buffett-indicator. It is the ratio of total market cap over GNP. As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”

As of today, the ratio is standing at 114.3%. If we assume the ratio will revert to the mean in 8 years, the market will average exactly 1% of return over the next 8 years, including dividends.

This seems very pessimistic. But the ratio has been quite accurate in predicting long term market returns.

Shiller P/E Ratio and Its Predictions

Shiller P/E, named after its invention Prof. Robert Shiller of Yale University, is another more objective measurement of the market valuation. As of today, it sits at 25.3, which is about 51.5% higher than the historical mean of 16.7.

Shiller P/E certainly indicates that the market is wildly overvalued. Historically only three periods the ratio was higher, the bubble of 1929, the tech bubble of 1999 and the financial bubble of 2007. The regular P/E is 21, which is also much higher the historical mean of 15.9.

We can use the similar revert to the mean methodology to calculate potential market returns. At today’s Shiller P/E, the market is likely to return 0.3% a year over the next 8 years, which is similar to the conclusion we reached from the Buffett indicator.

what happened in 2015

The past year was “supposed” to be a good one given the history of calendar and election cycles. Not only has the third year in the four-year election cycle been the best for stocks historically; years ending in “5” have nearly all been strong … until 2015.  But we entered last year with a more cautious stance on equities; and for now, we are maintaining that stance.

What drove performance … or lack thereof?

Remember, the S&P 500 is a cap-weighted index; and although it was about flat on the year, the average stock in the index did considerably worse—returning -3.8% according to Bespoke Investment Group (BIG), who took a look at what drove performance in 2015.

Market cap:  bigger was better. The 50 largest stocks at the beginning of 2015 were up an average of 1.5% by year-end; while the 50 smallest stocks were down 11.9%.

P/E:  growth was better. Price/earnings ratios were a factor, too; although perhaps not as you might think. The four deciles of stocks with the lowest P/E ratios (i.e., the cheapest stocks) were all down at least 5%; while the four deciles of stocks with the highest (or no) P/Es (i.e., the most expensive stocks) were all at least flat or up on the year.

Dividends:  none or lower was better. For income-oriented investors, note that the decile of stocks which started the year with the highest dividend yields were down 14.6%, while the stocks which pay no dividends at all were up 3.9%.

Momentum:  2014’s winners won again. The top six deciles of stocks which did the best in 2014 all averaged gains in 2015. The 50 stocks which did the worst in 2014 were down another 28% in 2015. Buying the losers of 2014 was about as painful as it gets.

FANG stocks ruled. The “fab four” stocks, now nicknamed FANG—for Facebook, Amazon, Netflix and Google (now called Alphabet)—were up over 60% on a cap-weighted basis. Excluding those four stocks, the S&P 500 was down 4.8% last year.

What’s happened following flat years?

Defining “flat” as the S&P 500 having a price-only (not dividend-adjusted) return between -2% and +2%, on a calendar year basis, the market has been flat in six years since the end of World War II. As you can see below, in each case, the market’s return the following year was positive by double-digits.

Source: FactSet.

The rub this year is that corporate earnings growth has been weak. In the highlighted “flat” years historically, each was followed by a strong earnings year. S&P 500 earnings are expected to lift out of negative territory this year; but if commodity price declines and dollar strength persist (the culprits to negative earnings), I would not place high bets on a strong year for US stocks.