What we saw earlier in the week is what I would call a quick risk off event in the global equity markets. In two days we went from complacency to panic. Implied volatility here in the US went from extremely low levels to highs that we have not seen since the financial collapse. This risk off event that culminated this week actually started some time ago with emerging markets. It then spread to oil and commodities, than spread to credit markets. The fixed income market has been weak, especially for investment grade and sub investment grade bonds. In a world starved for income, yields on high yield debt are closing in on 8%. The sell-off spread to China in June, then to Europe and Asia – European stocks are off 20% in the last 4 months – and finally this week to the US.
There was no shock to the market that caused the sell-off. The selling we saw was indiscriminate – more based on positioning and hedging than fundamentals. High frequency traders led the downdraft, followed by algorithmic traders. As the selling continued, margin calls ensued making the decline even steeper. ETFs, which generally make up about 13% of daily trading volume, saw volume increase to 29% of total trades. We actually saw fewer individual company stocks being sold. A side note, on the up days since, individual stock buying has picked up. As a result passive index investors saw their fortunes follow the ETF swoon while active managers seemed to fare better because of their individual stock selection.
To put the downdraft in perspective, the market was off almost 10% from last Friday to Tuesday. It had been a little over 1,300 days since we had seen the previous 10% downdraft. Corrections of 10% or more on average occur every 260 days, so you could say we were due, especially when you consider that from March of 2009 to last week, the S&P 500 was up a total of 190%. Remember the S&P 500 reached an all-time high in May.
We also know corrections tend to group together. We are not predicting that this will happen, but given the fact that the Fed will be exiting its stimulus program, which has been a boon for stocks, the possibility of returning to normality has increased. As we have been saying for a while, now that the Fed is no longer adding liquidity, we expect volatility to remain higher than the ultra-lows we have recently experienced. Assuming the Fed stays on course, we would expect the markets to go through a period of adjustment. While this may raise anxiety, it is good for the health of the markets and should be seen as a positive return to a functioning economy. In the near term, given the caution that already exists in the current market, we feel this sell-off will inject more caution.
Because markets from time to time do correct and we cannot predict when these corrections will occur, it is important to have a diversified portfolio with returns streams from many different sources. As a result we can participate in the market upsides while protecting on the downside. We have been using a number of strategies for risk management during the last 5+ years that have led to more stable risk profiles in portfolios. Given their unique nature, alternative investments are proving to be useful in helping to weather the current market storm. As of August 25th, the S&P 500 was down about 8% and the MSCI EAFE down almost 4%. In contrast, market neutral strategies are averaging down about 2%, managed futures are up 2.5%, global macro strategies are off .75%, and long/short equities are down 2.2%. Every Morningstar alternatives fund category is outperforming the S&P 500 index on a year-to-date basis.
These unsettling short-term movements can be quite stressful, but are an excellent time to reflect, not react. If you are feeling uncomfortable about the market dip, it might be a good time to talk to your financial planner and see if the change in your portfolio value has affected the chance of meeting your long-term goals. This discussion could take some of the emotion out of the decision. Studies consistently show that the average investor does poorly compared to every asset class due to the constant moving in and out of the market. To highlight this, data from JP Morgan states that from 1995-2014 REITS had an average annual return of 11.5%, the S&P 500 9.9%, a 60% growth/40% fixed income portfolio returned an average of 8.7%, bonds 6.2%, International developed stocks 5.4%, and the average investor had an annual return of 2.5%, slightly above the rate of inflation. That’s why it is important to stay invested, but also stay protected.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.