Broker Check

Return to Normalcy

February 05, 2018
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Feb 2, 2018 closing prices (source: CNBC)

Friday’s one-day 666 point drop in the Dow Jones Industrial Average was a shock for most market participants.

Predictably, media’s doom-and-gloom playbook is in vogue again: articles and airwaves over the weekend were dominated by hand-wringing over rising interest rates, falling dollar, Russia, North Korea, as well as the fact that the point drop coincided with the biblical Number of the Beast.

2017 Was Abnormal

By several measures, last year was the “calmest” year in a very long time. Consider the following (via LPLresearch.com, 10/23/2017, emphasis ours):

  • The S&P 500 index’s average daily change on an absolute basis so far [in 2017] has been only 0.30%, the smallest since 1965.
  • The S&P 500 index has closed lower 1% or more only four times—the fewest for a full year since 1964.

The overall calmness also led to an unprecedented streak of almost 400 trading days without a 5% correction. To see how rare this is, see below chart from Goldman Sachs:

Over the last 80-some years, there were only three other instances of this streak. Definitely not normal.

When conditions like these persist for months, we humans become conditioned to the “new normal” and then always make the mistake of expecting that the future will inevitably look like the present and recent past.

For this reason, bullish market sentiment in January of this year was extremely high. This is also why last week’s decline was especially jarring.

Back to the Old Normal

Biblical undertones aside, Friday’s decline was in the 2% range for the major US indices. The weekly decline for the S&P 500 was under 4%.

To put these in their proper context, consider the following chart (source: The Fat Pitch):

Since 1980, the median decline in the S&P 500 in any given year was about 10%. In roughly half of the years, corrections were even more severe.

Several 3-5% corrections are also the norm in nearly every year and rarely have any significant implications for the financial markets of the economy.

Last week’s sell-off was a sign that market volatility may be returning to levels consistent with its historical norms.

Benefits of High Volatility

Contrary to conventional wisdom there are many positive aspects of higher market volatility.

Market corrections that accompany high volatility are obviously a source of anxiety, but they also invariably create opportunities to buy high-quality assets at low prices.

The analogy we often use with our clients is that a market correction is no different than a Black Friday sale at your nearby mall when the price tag of everything you want becomes significantly discounted.

As any value investor will tell you, the best way to maximize your long-term investment returns is to always look to buy assets at low or, at the very least, reasonable prices.

The lack of volatility we saw last year forced investors to pay higher asset prices and thereby accept lower future returns.

Making matters worse, the persistent low volatility also led many investors to assume more risk than they should bear.

Living with Normal Volatility

Adjusting to the old normal should not be difficult or require major changes.

To paraphrase our article from two years ago, the most important things you can do to maximize your odds of success as an investor are as follows:

  1. Have A Plan – Long-term success in investing comes to those who have an investment plan tailored to their goals and needs. Risk management, in particular, should be an important part of every plan as it spells out how you should deal with different market conditions and reduces the odds you will make a harmful emotional decision.
  2. Stick To It – Given the long bull market we are in, many have forgotten that markets do naturally fluctuate (yes, they go up and down). Sticking to your plan through down markets and sitting on hands may be difficult, but is the best course of action to achieve long-term goals.
  3. Turn Off TV (or iPhone) – There is always a crisis, crash, war, or disaster somewhere. Following headlines/news, checking your portfolio every day, and then reacting is a great recipe to cause yourself a lot of grief and financial damage.

The above may be boring but that’s exactly how investing should be.

PLEASE NOTE: ABSOLUTELY NOTHING IN THIS ARTICLE SHOULD BE CONSIDERED AS INVESTMENT ADVICE OR RECOMMENDATION REGARDING THE SUITABILITY OF ANY INVESTMENT. FOR MORE INFORMATION PLEASE REFER TO DISCLOSURES.