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Game On and Risk Off: Thoughts on the S&P 500's Dismal January
Jason D. Edinger, CFA
Domestic equities stumbled out of the gate in 2016, defying the well-known January effect hypothesis. Generally speaking, the January effect is characterized as a period of optimism that marks the beginning of each new calendar year, whereby the broad market experiences a general increase in price and valuation throughout the month. This calendar anomaly, which suggests that financial markets may not be as efficient as investors believe, is attributable to several behavioral phenomena, but primarily arises from tax-sensitive investors who engage in loss harvesting at year’s end, only to reinvest during the month of January. While not a universally accepted premise such as Modern Portfolio Theory or the Random Walk Hypothesis, the January effect is still widely acknowledged as an implicit – and sometimes tradable – market phenomenon.
After the mediocre year we witnessed in 2015 – the S&P 500 returned -0.73% on a price basis and +1.19% including dividends – many investors were fully expecting the January effect to bring its force to bear when trading resumed on January 4th. While investors were anticipating global markets to come out swinging, in actuality the New Year rang in with very bearish undertones. Stock and commodity markets were moving + / - 2% or more on an almost daily basis, pressured downward by plunging oil prices, a slowdown in China, and anemic global economic growth, not to mention an entirely new round of Fed interest rate uncertainty. Given these significant challenges, it is not difficult to understand the carnage and chaos that have characterized the markets so far in 2016. Indeed, the S&P 500 has sunk straight down, returning -8% during the first 10 days of trading in 2016, the index’s worst opening fortnight ever. On January 20th, the S&P closed at a 52-week low for the first time since October 2011, breaking the fourth longest streak in the history of the index.
What feels different about this selloff, beyond the absence of the usual optimism, is a combination of several powerful factors. First, having enjoyed a remarkable bull market for nearly seven full years since the Global Financial Crisis (GFC) of 2008-2009, investors are simply unfamiliar with the sudden selloff and sustained volatility we see in the market today. As investors, we have notoriously short-term memories and, in the intervening years since the collapse of Lehman Brothers and American International Group (and all associated fallout), it appears that investors have been lulled into forgetting the pain and desolation left in the wake of the GFC. After all, why would we purposefully conjure up painful memories of outsized volatility, margin calls, the collapse of the mortgage market, and the greatest financial crisis since the Great Depression of the 1930s? By our nature we avoid such raw memories.
This correction also feels different because of its implications for global asset prices. Whereas in many historical cases a 10-20% correction in the S&P 500 would have a profound effect on US risk asset prices, it likely would have little spillover to global asset classes. We have seen the exact opposite phenomenon during the 2016 selloff that began on January 4th. As of January 31st, several notable MSCI International indices displayed the following net returns:
- EAFE : -7.23%
- ACWI : -6.03%
- EM : -6.49%
These international indices actually turned in a worse performance than the S&P 500 during the month, which was down -4.96% on a total return basis. These broad indices are not the only ones in the red. China, Germany, France, the UK, and a host of other developed nations are also in the midst of a correction. The Chinese stock market, the devaluation of the Yuan, and the oil price slump have all brought their influence to bear on US equity markets in ways that they have not done in the past. The key takeaway is that this selloff is global both in origin and in nature, which is a seemingly new twist on similar corrections that have occurred in the past.
Finally, the speed of the selling has been terrifyingly impressive, undoubtedly spurred on by high frequency, systematic, and other sell program algorithms that respond to changes in volatility and momentum across asset classes. The Dow Jones Industrial Average began the year with its worst 10-day start on record. The same can be said for the S&P 500. The pace of this correction has been much faster than usual, further adding to investor uneasiness and underscoring the notion that “this time is different.”
Volatility is Normal and Should Be Expected
As troubling as this selloff feels, if we look under the hood we find that in truth such drawdowns from previous market highs are not uncommon. Statistically speaking and using the S&P 500 as a proxy for “the market,” double digit peak-to-trough drawdowns historically have occurred with great frequency. Corrections of 10% or more from recent highs have been seen seven times in the last five years. Analyzing a 35 year time period, we have observed a 10% or greater correction in 19 of those years (~ 54% of the time). JP Morgan provides an exceptional chart below which details material drawdowns of the S&P 500 during the last 5 years with accompanying volatility metrics:
The chart does a great job putting market drawdowns in perspective when viewed in the context of a generally improving economy. Despite meaningful corrections occurring on average at least once or twice per year, the pullbacks have historically proved to be fleeting and transitory in nature. The question is: should this drawdown give us greater cause for concern than those we have experienced in the past? The answer to that question is unknown and elusive at present, but we can look to additional historical data which confirm that, not only are these drawdowns par for the course, but in many years the market can actually finish in positive territory despite significant intra-year volatility.
Again, we lean on JP Morgan for data and insight. As displayed in the following chart, beginning in 1980 we see that the average intra-year drawdown for the S&P 500 was -14.2%. Despite this sizeable average drop, the market actually finished positive in 27 out of those 36 years, or 75% of the time. For example, in 2003 the market was down -14% intra-year but still managed to return +26% for the calendar year:
There are many takeaways from this useful chart, but chief among them is the idea that double digit declines in the market are to be expected and should be recognized as being of little importance over the long term. In fact, 64% of all years during the test period experienced double digit drawdowns with 57% of those years finishing positive at year end. This provides a great reminder that volatility is normal, and even during the best performing years the market experiences corrections (see 1998, 2009 and 2013). As difficult as it may seem in the face of falling asset prices and chaotic markets, it is important to keep these data in mind and accept the fact that volatility is part and parcel of the larger investment process. The key is not to avoid volatility per se – that is nearly impossible to do with allocations to risky assets – but to understand the role volatility plays within a globally diversified investment portfolio.
The Importance of Staying the Course
With respect to RINET client portfolios, we are counseling clients to remain invested in the market, even when it appears that valuations are seemingly falling every single day. This counsel is predicated on our macro views regarding global asset classes and markets as we see them today. It is our opinion that US and global equity markets will neither collapse nor soar, but will likely offer more muted returns similar to those seen in the second half of historical economic cycles. Despite our belief that divergent central bank policy, geopolitical angst, and concerns over global growth will result in lower returns and elevated volatility going forward, we feel that remaining exposed to the US equity market broadly plays a pivotal role as part of a well diversified portfolio, and the recent market correction has not changed this belief.
The key to weathering periods of heightened volatility is to stay invested over the long term. Investors who unwisely withdraw when “blood is in the streets” not only crystallize losses and trigger taxes but also forego the mighty power of compound interest. For instance, if a lump sum were to be compounded at a 5% real return (i.e. after inflation) for 20 years, the result would be a gain of approximately 165%. If investors allow themselves to become intimidated by volatility and withdraw assets – especially at market lows – they miss out on part of the benefits of compounding and therefore their long term investment performance suffers. This is truly a “no pain, no gain” scenario.
We understand the inherent difficulty in this approach, but we believe this difficulty pales in comparison to trying to get in and out of the market consistently on an ongoing basis (i.e. trying to “time the markets”). Understanding these phenomena and incorporating them into client portfolios is a large part of the investment process at RINET. Accordingly we have positioned client portfolios to withstand the kind of elevated volatility that we are seeing today. As has been the case in recent years, we currently favor flexible, “go-anywhere” strategies that have larger and more comprehensive tool kits to deal with volatility relative to their long only brethren. We also look to our hedged and absolute return managers to not only temper volatility on a relative basis but also provide some level of positive absolute return.
Furthermore, from a total portfolio standpoint, we continue to believe in the power of diversification and remaining exposed to the four major asset groups – global equities, global fixed income, global hedged, and commodities – with periodic rebalancing as necessary. Regular rebalancing of portfolios forces investors to buy asset classes that have declined on a relative basis and simultaneously sell those that have increased in value. In the short term this process of rebalancing can be intimidating and sometimes painful, but over the long run (i.e. multiple market cycles) it will generally result in better portfolio performance with less volatility. And really, at the end of the day, the long run is what we are concerned with. While we have no crystal ball to predict future asset class returns, history tells us that over the long run there will always be some asset classes outperforming while others are underperforming. Although no portfolio is 100% insulated against difficult trading days, months, or quarters (or even years, for that matter), over time and with patience the globally diversified portfolio approach should allow client accounts to better navigate the troubled waters of volatile markets like those we are currently experiencing. This time is really not that much different at all.