Everything old is new again
October has a history of volatile markets and this year has not disappointed. In the past few weeks, we've seen equity markets shed their 2014 gains and then some, while fixed income yields have plummeted with the 10-year U.S. Treasury trading below 2.00% briefly. The summer was a lamb compared to the fall's lion-like volatility, making the recent turbulence all the more unsettling by comparison.
With that said, our overall view is we have merely been witnessing a correction within a longer-term bull market, like a bout of choppiness during a generally smooth plane flight. Corrections are not uncommon during bull markets and may actually serve to improve the overall health of the market as they help define downside risks. When markets dip, the price discovery process finds levels where traders and investors care enough to support it—thus defining a floor that can provide a base for the next round of upside trading.
While it may be tempting for investors to feel "this time it's different," let's pause for a bit of historical context: In the past five years alone, we've had 26 occasions where the market has sold off more than 5% from its high point—and nine of these selloffs were 8% or higher. Looking at the big picture, we comfortably reaffirm our belief that, when the dust settles, stocks will outperform bonds and cash, and maintain our positioning which favors stocks over both bonds and inflation hedges.
What's behind the volatility?
To understand the rationale for our positioning, we need to go back to how all of this dust got kicked up in the first place. The overriding culprit has been slowing growth in Europe, but there are also these factors:
When confronted with a list like this, we often find that what seemed important at the outset becomes less so over time. In fact, as we go to press, markets are already showing signs of rebounding. Strong bull markets usually end for real when recessions take place that are created by significant excesses or by monetary policy that has pushed interest rates up too far. At this time, we see none of these conditions within the U.S. economy.
Trying to get a handle on the business cycle in this post-financial crisis environment has been complicated by the extraordinary efforts of central banks here and around the globe. However, many of the conditions in the U.S. support being closer to the middle of the cycle than the end:
The one blemish has been the housing market, which has struggled in the wake of the credit crisis as home buyers in the 21-35 age group are faced with mounds of college loan debt that's limited their ability to make first-home purchases. Taking all of the above into account, however, along with the lack of any evident excesses, we feel the U.S. economy remains supportive of further advances in equity prices.
Some fear that what's happening in Europe (as far as slow economic growth) won't stay in Europe, but we do not share the concern that its troubles will reach our shores. Europe's problems initially surfaced shortly after the current expansion began to take hold back in 2010 and have been grabbing headlines periodically ever since. Then, as now, the bulk of their problems arises from systemic matters as opposed to global excesses, such as elevated interest rates, which could easily hurt both sides of the Atlantic. The European Central Bank (ECB) has unsuccessfully attempted to solve these systemic problems, and reforms that would promote growth and increase labor market flexibility but challenge accepted political positions have been ignored. At the same time, the once-powerhouse German economy that's helped keep Europe afloat has sputtered, mostly due to sanctions generated by the conflict in Ukraine and Russia (to which Germany is closely tied). Markets have been signaling urgency for the ECB's proposed reforms to be implemented and we see signs this will take place although not quickly.
We do not recommend making hasty investment decisions in fast-moving markets such as the ones we have been going through as illiquid conditions can arise and lead to price extremes. Today's investment world has significant assets invested in vehicles, such as exchange-traded funds, that must meet client requests for redemptions regardless of market levels. One move we would recommend once the market waters calm is to rebalance portfolios so they reflect target allocations. Given the major shifts over the last two months, equity allocations could be well below targets and fixed income just the opposite. Using current market weakness as an opportunity to rebalance reinforces the age-old but still-sage maxim: "Buy low, sell high" to achieve long-term investment success.
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