Investing in volatile markets; reasons for optimism in rough times
No one ever claimed that investing in the market was easy, or stress free. However, apart from the 4th quarter 2018, the markets have given us a relatively smooth ride for the past few years. This has the effect of lulling investors into a state of confidence, making market corrections even more jarring when they occur. For many, uncertain times like this invoke memories of the financial/debt crises in 2008, and bring to mind the white knuckle ride that went along with it as we saw markets fall. Believe it or not though, there is still reason for optimism.
The market expansion post 2008 is now the longest on record, progressing longer than many thought it would, or should have given the slow rate of growth and need for multiple rounds of quantitative easing in the US. The general sentiment in the industry is that the market is now in a late economic cycle, closer to the end of the expansion than it is the beginning, indicating volatility could increase. With the correction in late 2018, many analysts and fund managers were suggesting that the probability of a recession in the next 18 months was growing. At this point, even the most experienced investor could be forgiven for getting a little nervous.
There is currently no shortage of risks to the global economy in the short term. Continuing trade tensions between the US and China, the ongoing Brexit saga in the UK, and more recently unrest in the middle east. Any one of these factors alone could cause a market correction. More worryingly though is the possibility of a pullback being triggered by some yet unforeseen factor, or even set off by a shift in investor sentiment alone as was the case in late 2018. But wait, it’s not all doom and gloom. With multiple rate cuts from the US Federal Reserve among other factors, the general industry opinion now is that the dangers have eased, providing some tailwind to the economy. While this sentiment does not preclude the possibility of a recession occurring this year, it does provide a potential path for continued growth throughout 20201.
As investors we need to remember that market volatility is normal, and can even be beneficial for long term investing. Studies show that declines of 5-10% have historically occurred more than once per year on average and recoveries happen quickly, generally within one month2. Similarly, market corrections of 10% or more occur on average once every two years, usually lasting about four months and taking roughly three months to recover2. In either event, investment losses are usually short term, but provide some important purchase opportunities for active fund managers.
One of the advantages of active management, like actively managed mutual funds, is that the possibility exists for the fund managers to mitigate losses during volatile periods so that the funds do not decline as much as the index3. This is one of the most attractive features of active management when compared to passively managed funds, such as indexed ETFs, that are likely to realize the entirety of market losses. Market declines provide good active managers the opportunity to purchase shares in companies they feel are undervalued, much the same way that the rest of us might take advantage of a sale to purchase a big-ticket item at a significant discount. In this case though, the market volatility gives us the possibility of realizing additional growth as the market recovers. This exact scenario was exemplified by the correction at the end of 2018. Throughout October to December the TSX composite dropped more than 10%, panicking many investors. However, for those that stayed invested, markets recovered by the end of February, by December they were up more than 10% from before the correction, and up more than 20% from the their lowest point (see graph to the right). The steep decline and quick recovery we experienced in early 2019 reminds investors that sometimes patience is the most prudent course of action.
Fig 1. TSX Composite index from October 2018 - December 2019 showing market correction (in red), followed by a rapid recovery (in blue) (data adapted from Morningstar).
If small to moderate corrections are nothing to fear, when the market does begin to slide how do we know if it is a relatively short-term correction, or the start of a larger recession? That is the million-dollar question for all money managers and one that has yet to receive a satisfactory answer. We all wish we had a crystal ball that would warn us when a recession is imminent. The sad truth is that with the fast pace of modern computer-based stock market trading, and the growing impact of investor sentiment, even investment professionals can be taken by surprise. However, that does not mean that savvy investors cannot be prepared.
As Financial Advisors, we do our best to work with you, our clients, to create a customized portfolio that best meets your needs. Appropriately managing the fixed income ratio of your portfolio will help to mitigate the downside market risk. Further, we can discuss with you various investment options and explore market segments that may be more resilient to negative volatility. Not all companies perform equally in bear markets; during recessions consumers generally become more cognizant of non-essential expenditures. Therefore, carefully managing your asset mix by investing in certain sectors can be beneficial to helping you successfully navigate the storm.
There is one general rule to keep in mind when investing regardless of whether that market downturn is only a small pullback or the start of a larger bear market. If you are invested when the market begins to slide, stay invested! Reliably timing the market is impossible even for the best investors. Pulling money out of the market in a downturn will only serve to crystalize investment losses, and if you don’t reinvest at just the right moment you will miss the market recovery. Furthermore, the same philosophy of valuation applies to active fund managers here as above, investing during recessions often allows good money managers to make acquisitions of quality stocks “on sale” improving the fund returns as the economy recovers.
At Morson Deimling Financial Services we firmly believe that the key to investing in late stage markets is proper preparation. Experiencing volatility, especially after the relative stability of the last three years can be unnerving. However, as your advisors we can assist you to create an appropriate investment strategy, and more importantly help you to prepare yourself emotionally so that you avoid the common pitfalls of investing throughout turbulent times.