Perseverance in Down Markets

The first Sunday in April is always one of my favorite days of the year as it typically marks the final round of The Masters Golf Tournament. This year, defending champion Jordan Spieth entered the final 9 holes of the golf tournament with a 5 shot lead. He had been flawless through 63 holes and it was almost a foregone conclusion that he would march through the final 9 holes and be the first back-to-back champion since Tiger Woods in 2001-2002. He bogeyed 10 and 11. Then he stepped to the tee of the famous 12th hole, a 155-yard par three, the middle hole of the vaunted “Amen Corner.” The typical Sunday pin placement on the front-right side of the green tempted Spieth and he promptly deposited two balls in Rae’s Creek and went on to post a quadruple bogey. He would never recover and finished 2nd behind Danny Willett. While incredibly difficult to watch, Spieth is young and will have many more opportunities at Augusta. But make no mistake, he will have to persevere.

Golf and investing share a common trait: they can both be very humbling. This article is a follow up to my last article in which I discussed bear markets. Last time, I mentioned that bear markets in both stocks and bonds are very common. It just so happens that we are currently in one of the longest bull markets in the history of the US stock market. It’s useful in these times to create a plan to persevere once the next bear market occurs.

Keep a Historical Context

Let’s focus on the US stock market, specifically the S&P; 500 Index. See the chart below which tracks the S&P; 500 from 1997 until the end of the first quarter of 2016. It’s fairly easy to recognize up and down markets in this chart. Those with any money in the market in the past 20 years has certainly experienced these ups and downs!

Now take a look at a longer term chart. The chart below shows real (after inflation) returns of $1 invested in US stocks, bonds and bills from 1900 – 2015. Suddenly, that crazy first chart looks a little less crazy!

But wait, who has a 115-year time horizon besides large endowments and pension funds? Good question. The answer is very few individual investors have a 115-year time horizon. But most individual investors have a longer time horizon than 20 years! A freshly minted college graduate who starts investing at age 23 and lives to age 98 has a 75-year time horizon, closer to 115 years than 20 years. The point here is that as equity investors, you have to constantly remind yourself that equities in the long run will outperform bonds and cash. And you must remind yourself that down markets happen more often than up markets.

Take a look at the final chart and table from Ben Carlson. He shows here that when using monthly total returns on stocks, an investor during this time frame would have been in a down market 70% of the time!

Breaking this down further in the table below, Ben points out that over the last 90 years the market has been in a bear market almost one-quarter of the time and half the time you’re down 5% or worse!

Remember, remember, and remember.

Armed with this historical context, it behooves investors to not panic when the market goes down. Remind yourself next time there is a 5% or greater correction that this actually should happen more than 50% of the time.

“This is why stocks are constantly playing mind games with us. They generally go up but not every day, week, month or year. No one can predict what the future returns will be in the market. But predicting future risk is fairly easy — markets will continue to fluctuate and experience losses on a regular basis. As an investor in stocks you will spend a lot of time second-guessing yourself because your portfolio has fallen in value from a previously seen higher level. In a sense risk is easier to predict than returns. Market losses are the one constant that don’t change over time — get used to it.” Ben Carlson, A Wealth of Commons Sense

There’s a bull market somewhere!

In the famous words of Jim Cramer, “There is always a bull market somewhere.” He’s right, even though his analysis is typically tied to US stocks. Where he’s more right is when you widen your scope and incorporate all asset classes. One of the primary reasons to diversify your portfolio is based on this premise; there’s a bull market somewhere! A properly diversified portfolio should include US stocks, international developed and emerging market stocks. It should include large and small size companies. In the bond market, a portfolio should have US and non-US sovereign bonds, mortgage-backed bonds, corporate bonds, high-yield bonds, TIPS, emerging market bonds, and possibly strategies that incorporate bonds in varying currencies. Bonds need to vary in their duration, short-term to long-term, depending on the interest rate cycle. It’s also important to incorporate real assets such as commodities and real estate depending on valuation levels. However an asset allocation is developed, plan to stick with your strategy through thick and thin and always pay attention to costs and taxes.

Have a plan.

Creating your plan to endure down markets in the midst of a good market is important. I’ll simply reiterate a few points from last time.

• Don’t panic. Keep a long term perspective relative to your stock holdings. Remind yourself that stocks are volatile assets and will go up and down more often than bonds and cash.
• Continue to invest on a regular monthly basis. As stocks decline, you’ll be buying at lower prices.
• Rebalance your portfolio. If the market drops 20% that usually means your allocation to stocks has also dropped 20% while your allocation to bonds has increased 20%. Selling the winners and buying the losers, allows you to again take advantage of lower stock prices.
• Keep an eye on international stocks, bonds, and real assets. Ensure proper allocation globally in a portfolio.

Global Market Update

Global stocks declined by 0.4% in the first quarter. U.S. stocks were slightly higher, while emerging market stocks rebounded to return almost 6% on the quarter. Even after its strong quarter, emerging market stocks still trail US large cap stocks by 12% annually over the past 5 years. The US dollar retreated from its highs despite efforts from the European and Japanese central banks suppress the Euro/Yen vs. the dollar. Commodities were flat, but were up big in the month of April.

The global bond market advanced 6% led by emerging market bonds and corporate bonds. US treasuries were also strong as the stock market was weak in the first part of the quarter.

A mix of 60% global stocks and 40% bonds retreated 1.3% year over year, but is still up 5.4% annually over the past 5 years and 4.5% annually over the past 10 years.

References

A Wealth of Common Sense – Ben Carlson.

JP Morgan Guide to the Markets – As of 3/31/2016.

Credit Suisse Global Investment Returns Yearbook 2016.

DISCLOSURES & INDEX DESCRIPTIONS

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