An Awakening Bear?

Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.

—Peter Lynch

On Oct. 10, 2018, the S&P 500 Index fell 3.3%. The 11^thwasn’t much better, with the index dropping a further 2.1%, producing a two-day loss of 5.4%. These drops occurred without any bad economic news. In fact, Federal Reserve Chairman Jerome Powell indicated it was the Fed’s view that the economic recovery was robust. And most economists are forecasting continued strong growth into next year.

Looking for an explanation, most market commentators blamed the drop on the expectation that the Fed will continue to raise interest rates. However, the market was already expecting several more rate hikes over the next year. Further, on the 11^th, the news on inflation was benign, with the August Consumer Price Index increase at just 0.2%, producing a 12-month rate of just 2.3%. Other explanations were tied to trade-war concerns. However, all of these facts were well-known prior to the 10^th, and nothing had really changed.

While markets often move for no apparent reason (think of the recent flash crashes we have experienced), it’s an all-too-human trait to seek explanations, to find patterns in what could be randomness. And that search for explanations can lead many investors to abandon even well-thought-out plans. Before you succumb to such an urge, I suggest you consider the following.

A good place to start is to see if there is anything unusual about the two days we just experienced. Such large moves in a single day might seem unusual. After all, over the past 92 years, stocks have provided annual average returns of about 12%. Thus, a more than 3% move in a single day is more than 25% of the average annual return. And the two-day move we experienced is more than 40%. However, stock returns are not normally distributed.

Distribution of Stock Returns

Benoit Mandelbrot and Richard Hudson examined the daily index movements of the Dow Jones Industrial Index from 1916 to 2003. They noted that if stock returns were normally distributed, a single-day price move of more than 3.4% would have occurred 58 times. The actual number of occurrences was 1,001, more than 17 times as frequently.

They found that a daily price move of more than 4.5% would have occurred just six times, yet it occurred 366 times, or 61 times greater than with a normal distribution. They also found that a daily price move of more than 7% would have occurred just once in every 300,000 years. Yet, it had occurred 48 times!

In other words, markets are risky, and returns exhibit excess kurtosis (the tails are much greater than would be expected if returns were normally distributed). Thus, we can conclude that large moves such as we have seen in the last two days are “normal” in the sense that they should be expected, although we cannot predict when they will occur.

It’s also worth noting that, according to Ken French’s data library, the U.S. market had negative returns of 106, 212, 402 and 367 basis points over a span of eight days in late January and early February. The other four days experienced either modestly negative or positive returns. In total return terms, the U.S. market fell 9.3% over that eight-day stretch.

To my knowledge, there is no evidence that such large drops forecast continued negative returns for the longer term. Considering the following evidence covering the period since the end of the Great Financial Crisis. I examined how the S&P 500 Index performed after a month in which it had experienced a drop of at least 5.0%, rounded to the nearest 10^th of a % (roughly the size of the loss from Oct. 10-11). We have had six such periods.

The table below shows the returns over the succeeding six and 12 months. As you review the data, keep in mind that two of the episodes of losses of more than 5% in a month happened back to back (creating a hurdle for the period following the first of the two down months).

Exiting Investors Missed Out

Investors who sold because they panicked missed out on returns that were well above the historical averages. Evidence such as this is why Warren Buffett has warned investors against market timing. He has advised investors that “inactivity strikes us as intelligent behavior,” and noted that “the most important quality for an investor is temperament, not intellect.”

Commenting on Berkshire Hathaway’s strategy, he noted: “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.” However, he also advised that if you cannot resist the temptation to time the market, you should do the opposite of what most investors do and “be fearful when others are greedy and greedy when others are fearful.”

Of course, despite Buffett’s advice and the data presented in the above table, there is no guarantee that the next time we have a month with a large loss that the succeeding period will not produce massive losses—as was the case after January 2008 when the S&P 500 lost 6.0%. Over the next six and 12 months, it lost another 7.1% and 38.6%, respectively. Stocks are risky investments.

And as a reminder that large losses are frequent occurrences that must be built into plans, my colleague and co-author Jared Kizer examined the data on the maximum drawdown of the U.S. equity market in each month from July 1926 through September 2018 and found that 25% of months had drawdowns of at least 5%; 6% of months had drawdowns in excess of 10%; and 2.5% of months in excess of 15%.

Don't Mistake Recency

Unfortunately, many investors are subject to the mistake of recency, projecting the recent past almost as if it will continue indefinitely into the future. And we have not had a recession or bear market now for almost 10 years.

However, it’s important to remember that we have had three severe recessions and bear markets over the past 35 years, each producing losses in excess of 40%. That is why it is critical you have a well-thought-out investment plan, one that doesn’t take more risk than you have the ability, willingness or need to take. Those who take excessive risks are much more susceptible to panicked, or forced (by circumstances such as unemployment), selling.

With that in mind, now is always a good time to reassess your asset allocations to make sure they are consistent with your ability, willingness and need to take risks. It’s also a good time, having gone through a long period of strong performance for most portfolios, to see if you are able to “take some chips off the table.”

At my firm we use Monte Carlo simulations to determine if investors are able to lower their equity allocations and still have a high probability of achieving their goals. We do this on a regular basis. You should do the same.

There’s another point we need to cover.

Losses Create Opportunities

There is an old saying that “there is a time for everything, and a season for every activity.” While this may be true for activities like harvesting crops, it’s not true of harvesting losses for tax purposes. Tax management is a year-round job.

Far too many investors and advisors wait until the end of the calendar to check for opportunities to harvest losses. A loss should be harvested whenever the value of a tax deduction significantly exceeds the transaction cost of the trades required to harvest the loss, immediately reinvesting the proceeds in a manner avoiding the wash-sale rule.

We were provided a perfect example in 2009 of why waiting until the end of the year is a mistake. Losses that might exist early in the year may no longer exist—losses that could have been harvested in March before the rally that began may have been turned into gains by year end.

It’s also important to be sure you are examining your fund holdings by each individual loss, as there may be opportunities to harvest losses on more recent purchases, but not on purchases made long ago.

Crucial Order

Further, it’s important to realize any short-term losses before they become long-term losses. Short-term losses are first deducted against short-term gains that would otherwise be taxed at the higher ordinary income tax rates. Long-term losses are first deducted against long-term gains that would otherwise be taxed at the lower capital gains rates—another reason not to wait until year end.

For example, before any loss harvesting, imagine a taxpayer has realized short- and long-term gains and unrealized short-term losses. These losses can be harvested, reducing the short-term gain that would have otherwise been taxed at higher ordinary tax rates. If not harvested until they became long-term losses, they would reduce long-term gains that would have been taxed at the lower long-term capital gains rate.

Before closing, it would be helpful to note that, as noted earlier, the economic outlook is strong and bull markets and strong economies don’t come to an end because of age (gurus often comment that we are in the eighth inning of this recovery, but there is nothing to prevent the “game” from going into extra innings).

There are always risks to investing. Bear markets can occur because of risks that we are well aware of; or, they can come from so-called black swans (unforecastable risks such as the events of September 2001). And stocks can fall sharply without the real economy turning down.

For example, from July 28, 1998 to Sept. 4, 1998, the S&P 500 lost 15.1% (the failure of the hedge fund Long Term Capital caused the drop), and European stocks dropped about twice as much, while the U.S. economy kept roaring along.

Key Market Considerations

While the following is not meant to either scare anyone into selling, nor even as a forecast, it is meant to make you fully aware of the risks, and that you don’t blindly fall subject to the excessive optimism that bull markets can create. In other words, it’s worth remembering that stocks are risky investments.

U.S. equity valuations are at historically high levels, with the CAPE 10 currently at about 31. That’s almost double its long-term average. However, that doesn’t mean the market is overvalued, just highly valued. You can see my presentation on why I believe this to be the case here, and read my ETF.com article here. And that means expected returns are much lower than the historical return of 10%.
At the same time, while bond yields are well up from their lows, they are still well below historical averages. Most economists attribute this to the Fed’s policy of financial repression, which is now being unwound. Historically, longer-term bond yields have been roughly equal to the nominal growth in gross domestic product. Thus, while the 10-year Treasury is yielding about 3.2% as I write this, the Philadelphia Federal Reserve’s Third Quarter 2018 Survey of Professional Forecasters is showing a 2019 forecast of real GDP growth of 2.8% and an expected inflation rate of 2.3%, producing a “natural” rate of 5.1%, almost 2% greater than today’s levels. Those higher rates would not only lead to poor bond returns, but increased competition from higher yields could have a significantly negative impact on stocks. In that scenario, bonds want be helpful to portfolios as they were in the bear market of 2008.
Such an increase in interest rates would dramatically impact the budget deficit, which is already exploding due to tax cuts, rising entitlement costs and increased defense spending. Added to that, there are concerns as we move closer to the date when Social Security will no longer be able to meet its full obligations. We are now only about 15 years away from the fund being able to pay out perhaps only 75% of promised benefits. And consider the potential impact on the credit rating of Treasuries and what a downgrade would entail.
The Federal Reserve is now beginning to unwind the “great experiment” of growing its balance sheet by buying Treasury bonds to stimulate the economy (and help the stock market) by suppressing interest rates. The negative real interest rates that resulted did their job. But no one knows how this experiment will end. There is no way to know if there will be a correction in asset prices that will be deeper and last longer because the Fed’s policy was so extended. No one knows the impact on the real economy either.
While it appears that President Trump has been successful in negotiating several bilateral trade deals, there is still the risk that a full-scale trade war with some of the major global economies could occur. The Chinese economy and stock market are already feeling the effects. And it is hard to see how a slowdown or recession in the world’s second-largest economy cannot have some negative impact on the rest of the world.
Italian debt looms as a potential “black swan”: the next Greece. And Italy is a much larger economy. An Italian debt crisis could lead to a contagion similar to the “PIGS” (Portugal, Ireland, Greece and Spain) crisis we had in 2011.
Corporate profits as a % of GDP are at historically very high levels—about 50% above their average since 1952. And if there is any metric that has a tendency to revert to the mean, it’s this one. The same tendency toward mean reversion is true for corporate profit margins, which are at record levels. While a strong labor market is good for the economy, with unemployment now below 4%, corporate profit margins could come under pressure as competition for workers enables labor to gain a greater share of revenue. If profit margins reverted to their mean, even if the process took several years, stock market returns would be negatively impacted unless sales growth increased rapidly and/or price-to-earnings ratios rose to offset the drop.

The market is well aware of all of these risks. And it was just as aware of them prior to Oct. 11. That is why I’m selling neither stocks nor bonds. I’m pretty confident Warren Buffett isn’t selling either. (If you are thinking about selling, you might ask yourself what you know that Buffett doesn’t.)

My plan already incorporates all the above risks, and my equity allocation reflects my own ability, willingness and need to take risk. I’ve also diversified my portfolio to include exposure to alternative investments that have historically had low to no correlation to traditional stocks and bonds, which should provide some protection against the left tail (black swan) risks of stocks. The alternatives I own are QRPRX, QSPRX, LENDX, AVRPX and SRRIX. (Full disclosure: My firm recommends AQR and Stone Ridge funds in constructing client portfolios.) And my firm recommends that investors consider including allocations to them in order to diversify their sources of risk and reduce the potential dispersion of returns.

Summary

Napoleon Bonaparte, perhaps the greatest general of any era, noted that “most battles are won or lost [in the preparation stage] long before the first shot is fired.” Investment “battles” are also won in the preparatory stage through the development of that well-thought-out investment plan—one that includes the virtual certainty that you will experience many bear markets over your investment lifetime. Those prepared for them, by not taking more risk than they can handle, are far more likely to avoid the panicked selling that dooms so many investors.

Larry Swedroe is the director of research for The BAM Alliance.

This commentary originally appeared October 15 on ETF.com.

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