August 22, 2015
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
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Today’s market capped a volatile week for investors, with the S&P 500 down 3.2% on Friday and 5.8% for the week. Friday’s selloff was triggered by reports that Chinese manufacturing sentiment hit its lowest levels since 2009. While low growth in developed markets has been expected, additional news that the world’s second largest economy may be slowing down more sharply than had been anticipated has created additional uncertainty for investors.
Earlier this week, minutes released from the Federal Reserve’s most recent monetary policy meeting suggest board members are divided on the outlook for interest rates. There had been a consensus building that rates were set to rise either in September or December, reflecting the Fed’s belief that the economy was strengthening. However, recent inflation and economic data has refueled the debate about whether it is too soon to start raising rates and risking what momentum the US economy currently has. This week’s market reflects the fact that as uncertainty grows, volatility typically follows.
While this is the largest drawdown for the S&P 500 this year, we are more surprised by how long it has been since the last 5% decline. Heading into Friday’s trading session, the S&P 500 had gone 213 days without declining 5% from its peak, marking the longest such streak in 11 years. Additionally, the index has not experienced a “correction” (a period defined by at least a 10% decline from recent highs) in almost four years. Historically, the stock market experiences such corrections about once every year-and-a-half.
Market volatility is normal, and it is part of why investors are paid a risk premium for owning stocks. Looking back over the last twenty five years (chart below), we can see that a meaningful drawdown has occurred during the years identified by the red dots. Despite those intra-year declines, which average -14.2%, stocks have finished higher in in 27 of the 35 years (or 77% of the time).
As our clients know, Miller Russell Associates’ portfolios have significantly less volatility than the S&P 500. Allocations to fixed income and multi-strategy assets, including reinsurance, farmland, and low volatility investments, help dampen the impact of volatile markets while still delivering returns. Furthermore, in 2014 we paired the most volatile part of equity allocations (small cap and international equities) with a variance risk premium strategy specifically designed to reduce downside participation. Through last week those allocations had contributed to an average of 1% outperformance relative to the index in small cap and international markets, and have continued to add value this week.
Volatile markets can present opportunities to add value in other ways. For our taxable clients, extended declines in certain asset classes allow us to harvest a tax loss to offset current or future gains in the portfolio, increasing the after-tax return for clients over longer periods of time. As markets drift away from target allocations due to volatility, we take the opportunity to sell those asset classes that have outperformed and buy those asset classes that have underperformed, effectively selling high and buying low. The discipline of rebalancing adds significantly more value over time to portfolio performance than trying to time when to buy or sell certain markets.
While market volatility can be unsettling at times, we want to reassure our clients that we are neither unprepared nor overly concerned at this time. The current volatility is not abnormal, and may be resolved over the next several months with clarity from the Fed and stability in foreign markets. Even if volatility ensues, we remind our clients of the profound impact of time. Looking beyond the current week, month, or year to the true time horizon of many years, one can see that short-term volatility has less and less of an impact on stock markets, and even less on diversified portfolios.
Should you have additional questions or concerns, or you want to discuss markets and your portfolio in greater detail, please reach out to your Miller Russell Associates engagement team.