The markets finished the first four months of the year very poorly.
The MSCI global stock index fell by 12.9 percent. High-quality bonds offered no relief: the Bloomberg Global Bond Index fell 11.3 per cent. To prove that there was nowhere to hide, even a classic balanced portfolio of 60 per cent of global stocks and 40 per cent of global bonds incurred a 12.3 per cent loss. The markets have entered a new phase.
Let’s say the “normal” return for any 12-month period is between a 20 percent loss and a 20 percent gain. On that basis, the S&P 500 behaved “normally” during 65.7 percent of all 12-month periods traded between 1990 and 2021.
Of the remaining 34.3 percent, 29 percent were significant (more than 20 percent), and 5.4 percent were terrible (a loss of more than 20 percent).
During normal periods, there is not much difference in average returns between the S&P 500 Index, the Bloomberg US Aggregate Bond Index and a balanced portfolio consisting of 60 percent of the former and 40 percent of the latter.
It’s another story entirely during the 34.3 percent of the time when bull and bear markets are in their most dynamic phases. The good news is that there are some basic signals and basic rules that offer good odds of getting respectable gains in major bull markets, while avoiding the ruins from the worst phases of major bear markets.
Don’t fight the Fed
The trend in interest rates is the dominant factor in determining the main trend of the stock market.
When central banks cut interest rates, it’s a good bet that it won’t be long before stocks generate attractive returns. In late 2008 and early 2009, central banks responded to the collapse of financial markets by cutting interest rates sharply. This led to a rapid recovery in asset prices. Likewise, to offset the economic fallout from the COVID-19 pandemic, monetary authorities flooded the global economy with money, which served as a rocket fuel for stocks.
Conversely, when central banks raise interest rates, the effect can range from benign to causing a complete bear market. Once the US Federal Reserve started raising interest rates in mid-1999, it wasn’t long before stocks found themselves in the midst of a vicious bear market that halved the S&P 500 over the next two years. Similarly, when the Federal Reserve raised its target rate to 5.25 percent in mid-2006 from one percent in mid-2004, it set the stage for a sinister crash in debt, stock and real estate prices.
It’s all fun and games until prices go up, which eventually breaks things down.
Never fight tape
The importance of not fighting major movements cannot be overemphasized. Fighting tape is an open invitation to disaster.
Investment legend Marti Zweig has compared fighting a strip and trying to pick a bottom during a bear market to “catching a fallen safe.” Zweig, who died in 2013, stated: “Investors sometimes crave its valuable contents so much that they ignore the laws of physics and try to snatch security out of the air as if it were a pop-up fly. You can get hurt doing this: see the records of bottom collectors on the street. Not this game. It’s not only dangerous, it’s also useless. It’s easier, safer, and in almost all cases, to wait for the safe to hit the curb and bounce a bit before grabbing the contents.”
Here’s how to turn the painful test of market correction in your favor
This decline in the stock market is different, but this does not mean that investors should panic
As the stock sell-off heats up, opinions abound as to where it will end up
Only geniuses and/or liars buy at the lows that precede major uptrends and get out of the top before the bear markets begin. Realistically, you can only hope to catch (or avoid) the bulk (instead of all) the big moves.
It doesn’t matter if you are a bold or conservative investor, as long as you are a resilient investor. Conservative portfolios tend to remain defensive, regardless of the market environment. Likewise, bold investment portfolios tend to stand in the weak and thin.
Neither approach is sound in itself. It’s okay to be aggressive, but there are times when it’s a sunflower. Along the same lines, there are market environments in which even conservative investors have to be somewhat aggressive.
A slap hurts less than a hit
The only consistent way to make money in the market is to make profits and cut losses. A slap in the face, represented by a 15 percent drop in prices, should be neutralized rather than allowed to spread to a heavy blow. It’s easier to recover from a slap like this than to hit a bear market which can leave you in a bad position to pursue future gains once the markets start to recover.
The economy has nothing to do with stock prices
Even if market strategists can anticipate economic growth over the next one to four quarters, that doesn’t mean they can anticipate bullish or bearish markets. In the near term, earnings and stock prices have nothing to do with each other.
If you want to forecast the economy, look at the stock market. Stocks are always looking ahead, peaking long before the economy happens, and hitting lows before recessions.
Where do we stand today
The markets have been, and may continue to be, in one of those rare periods where portfolio positioning can produce dramatically different outcomes.
In a world of high inflation, high interest rates, and low stock prices, it would be wise for defensive investors to remain so, and for bold investors to reduce their risk. Also, in an environment where price gains become scarce (or non-existent), high-flying, growth-oriented companies tend to underperform their value-oriented counterparts. By the same token, dividends (which are much less volatile than prices) take center stage in terms of their share of contributions to total portfolio returns.
Noah Solomon is Chief Investment Officer at Outcome Asset Management Ltd.