Stocks are seemingly indefatigable, marking their seventh consecutive month of positive returns. In this month’s commentary we address:
• Equity market volatility exhibits an inverse relationship with stock/bond correlation. This is a benefit to managed risk funds.
• As a result of ongoing low volatility, managed risk funds have generally implemented their respective maximum equity allocations for most of 2017.
• Market-based measures of financial risks are near precrisis lows. How does a managed risk approach fit in that context?
S&P 500 dividends have increased at more than two times the rate of inflation over the last 30 years.
The S&P 500 CAPE ratio sits above its pre-crisis peak. Year-over-year PCE, the Fed’s preferred measure of inflation, climbed above 2% for the first time since 2012. An ocean of excess reserves diminishes the Fed’s ability to respond to inflation. Risk management, like insurance, is only a benefit when implemented ahead of a risk event.
Recent market declines appear to be driven by a few primary factors: the purported North Korean hydrogen bomb test, tensions between Iran and Saudi Arabia, an oil glut causing the lowest price per barrel in a number of years, along with continuing concerns about growth in China, have all contributed to global market instability in recent days. Not to mention, we are entering into a presidential election year in the United States. While we have no way to predict the outcomes of these economic and geopolitical issues, we do view them with some historical perspective and insight.
We are seeing some positive aspects in domestic economics with the U.S. Labor Department indicating better job growth during the last three months and hourly pay rising 2.5%. The U.S. unemployment rate remains steady at 5% and is the lowest it’s been since 2008.
Since the end of December, the Dow Jones Industrial Average has dropped nearly 1,000 points and the S&P 500 has fallen nearly 121 points, amounting to percentage declines of around 6% in the first week of 2016. If you look back to January 2015 and January 2014, we began both years with declines in the U.S. equity markets early in the month, continuing into negative territory to finish off January. In both of those years, the market rebounded during February and ended the quarter with better results than January might have predicted.
This is not to say that we are expecting or predicting the same type of rebound during February 2016, but it shows that, from a historical perspective, the January effect doesn’t provide the full story. As you can see, rocky starts were followed by healthy rebounds as we moved into the mid part of the first quarter in each year.
More currently, during August 2015, the markets experienced a sharp correction of more than 11% over a period of six trading days from August 18 through August 25. During that period, market volatility rose significantly, as noted in the VIX Index (see chart below). The VIX, a market volatility indicator, jumped significantly during this time from the 10-to-15 level prior to the correction to over 40 during the first couple days of the decline, and remained moderately high through September.
During this time, we saw the market attempt a rebound on a couple of occasions, but ultimately it dipped again in the last week of September. The return of the market to pre-correction levels took the entire month of October, finally ending the first day of November with the S&P 500 hitting 2,100.
At this point, as an investor, you are most likely asking yourself what, if anything, should be done. Looking at historical market patterns and movements, there is a tendency for investors to be cautious when the market ventures into near-correction territory. Concerns associated with market declines often lead to unwarranted or ill-timed actions. Remember to look at the long-term aspects of your investment strategy. Market setbacks and corrections are always a part of long-term investing. Keep in mind your risk tolerance while thinking twice before making any significant portfolio adjustments.