So ran the breaking news banner on CNBC in my office shortly after 4 p.m. on Monday, February 5, 2018. The Dow Jones Industrial Average (DJIA), after dropping 1600 points intraday, closed down 1,175 points, or 4.6%, erasing the year-to-date gains for 2018. The selling pressure in the afternoon was likely exacerbated by a confluence of algorithmic trading programs indiscriminately selling based upon technical levels, momentum strategies closing out positions, and a very overcrowded short volatility trade being squeezed as the volatility index (VIX) spiked over 100% intraday. This downdraft, after the drop on the preceding Friday of more than 2%, can obviously be unnerving. We encourage investors to remember the following:
- Corrections Are Normal: 2017 was the first year on record in which we did not have a market correction of 3% or greater. Corrections of 5% to 10% are very normal in bull markets. The tranquility in financial markets over the past 18 months is not normal. It has mesmerized some into thinking stocks only go up, and if they do fall, they do so for only a short period of time. Stocks have historically earned more than bonds because investors bear more risk. That shouldn’t be forgotten. A correction to remind investors of this truth can be healthy and can lengthen the duration of a bull market.
- Rising Stock Valuations Mean Risk Is Increasing, Not Decreasing: It is a cruel irony that investors seem to most want to buy stocks after they have risen for some time and are growing ever more expensive. Stocks have risen much more quickly in recent years than underlying earnings would have suggested. Which in plain English means investors were increasingly willing to pay more for each dollar of earnings. This is reflected in numerous valuations metrics, which from a historical perspective, look quite rich. Investors shouldn’t be alarmed by a normal market correction that lowers valuations, thereby improving future prospective returns. In fact, long-term investors should be enticed to be buyers as valuations improve, not sellers.
- Risk Happens Fast: The proliferation of algorithmic trading and trend-following strategies over the past 10 years has arguably made the internal market structure more brittle and susceptible to rapid declines. While market corrections are indeed normal, the rapidity of the moves seems to be increasing. Given this, it is more important than ever for investors to stay focused on their risk tolerance, time horizon, and specific goals, using these fundamentals to guide their overall asset allocation. Doing so can prevent being a nervous seller in a violent short-term correction.
- Stock Prices Change More Rapidly Than Fundamentals: The DJIA suffered a 7% drop in just two trading days. Did the economy suddenly weaken in the past week? No. In fact, the Atlanta Fed’s GDPNow tracker is projecting the economy will grow at 5.4% annualized pace in the 1st quarter of 2018. Are corporate profits plummeting? Not so much. Companies are reporting record quarterly profits for the 4th quarter of 2017. Then what is going on? Could it be as simple as the market was long overdue for a correction as people were becoming too eager to buy stocks, regardless of the price, because they were going up, which led to an increasingly lopsided market ripe for a correction? Indeed.
Frequent readers of our commentaries and blog posts know well our concerns about how richly valued many asset classes have become. As such, our model portfolios have been near the lower band of risk exposure coming into 2018. While we do not enjoy seeing the market decline, we are prepared to increase the risk exposure in our models if valuations continue to improve.