Our perspective on the recent decline of the stock market

The S&P 500 reached a high of more than 2,900 in mid-September but has since declined to about 2,700, representing a high single-digits decline. Despite this drop, the S&P 500 is still close to flat for the year. Market volatility, however, has clearly been increasing, causing investors to worry about what might happen from here. Some investors have also been concerned about the Federal Reserve’s plan to continue increasing the federal funds rate as well as the poor performance of international and emerging market equities, which are both down year-to-date. We want to share our thoughts about how you should think long term about market movements and what, if anything, you should do in response to these events.

Among other things, we always advocate global stock market diversification since we have no way of knowing which particular country will generate the best long-term returns.

First, know your long-term plan incorporates market risk.

When we work with you to determine an allocation, part of that process involves examining that portfolio’s historical risk. This historical experience goes back to the 1970s and therefore incorporates the financial crisis of 2008–2009. This data shows that equity markets experience declines in about 25 percent of quarters and in about 15–20 percent of years. Experiencing this risk is why markets have also rewarded long-term stock market investors with higher returns than safer investments like fixed income. In addition, the risk we are currently seeing is well within historical ranges for all the portfolio allocations we utilize.

Second, know that predicting short-term market movements is virtually impossible and making portfolio adjustments in response isn’t wise.

Over and over, academic research has shown that no one appears to be able to reliably forecast short-term market movements. As Warren Buffett famously said, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” Don’t forget that we had a significant decline in the S&P 500 in late January/early February of this year. Many predicted the U.S. market would continue to decline from there, but that period was instead followed by very strong U.S. market returns until the mid-September period referenced above.

Third, the stock and bond markets are aware of the Fed’s plans to continue increasing the federal funds rate.

One particular concern we’ve heard some investors express is the fear that continued increases in the federal funds rate will cause either the stock or bond market to fall further. We’re skeptical of this claim since both markets seem to be fully aware of the Fed’s plan given it has been clearly articulated for well over a year. It’s also important to understand that most bond strategies that we utilize in client portfolios have relatively low sensitivity to interest rate changes and are close to flat in terms of year-to-date returns.

Fourth, we’ve also heard concern about trade.

No doubt, there is increased risk of trade retaliation, but that’s likely one of the reasons the markets are off their highs from earlier in the year, and likely a reason that emerging markets have done poorly relative to developed markets. The question, though, is whether these risks are unknown to the market or have been mispriced. We would say absolutely not to the former and that it’s impossible to know on the latter. Our best estimate is that stock markets have adequately priced all the potential trade outcomes and that trying to outguess the market isn’t productive.

Fifth, remember that your stock fund allocation is globally diversified and your fixed income allocation is expected to buffer stock market risk.

The performance of your stock fund allocation is not solely driven by the performance of the U.S. market but rather by the performance of global equity markets. It’s completely within the realm of possibility that the risk experience from here could be elevated for the U.S. market compared with other markets. This is one of the reasons why we’ll always advocate global stock market diversification since we have no way of knowing which particular country will generate the best long-term returns. Further, we maintain a very high-quality approach to the fixed income portion of your portfolio. More often than not, when the stock market does decline significantly, the fixed income portion of your portfolio will either be holding its ground or appreciating, providing a risk-reduction benefit.

So what might make sense to contemplate at this point? First, if the recent risk experience has made you uncomfortable let’s set up some time to talk. You should be comfortable with the risk profile of your portfolio and sometimes talking this through can help set better historical context. Further, we can look to harvest losses to offset future capital gains. Finally, these recent events only reinforce the value of considering alternative investment strategies.

Click here for more perspective on the awakening bear market from Larry Swedroe, director of research of the BAM ALLIANCE. Kraft Asset Management, LLC is a BAM Alliance firm.