Patience Pays in Volatile Markets
With the recent uptick in market volatility and the poor start to the year for the U.S. stock market, I wanted to recap where markets stand and reiterate three time-tested principles that I believe are as relevant now as they have been over the modern history of financial markets.
Zooming out, it is first important to understand just how extraordinary the performance of the U.S. market has been since the end of the 2007-2009 financial crisis. Save for a few (mostly) minor blips and of course a big dip in early 2020, the U.S. market achieved one of the best 10-year and longer stretches in its entire history, especially considering how low interest rates were for most all this period. If we look at the shorter period since the March 2020 bottom, the U.S. market was up 122% through the end of 2021.1 In other words, the broad U.S. market has done exceptionally well over the recent and more distant past.
As we all know, government stimulus and central bank monetary policy bolstered financial markets in early 2020, but because of that support we are now seeing high realized rates of inflation and consequent upward pressure on interest rates. No doubt those factors are driving some of the volatility that we are currently experiencing.
Regardless of inflation or interest rates, the valuation of the U.S. market (but not most other stock markets) relative to the earnings that companies are generating remains at levels not seen since the late 1990s. While high valuations do not guarantee volatility or sharp downward movements in the U.S. market in the near term (and even if they did, successful market timing — trying to anticipate when the downward movements will occur — is nearly impossible), I believe they do mean that investors should prepare for relatively low long-term expected returns from the broad U.S. market. In other words, while some investors have been tempted to abandon everything other than U.S. large-company stocks in recent times, I believe diversification across a wide range of asset classes (international and emerging markets stocks, value stocks and potentially alternative investment strategies) will be crucial from here.
Before I cover key, long-term investment and planning principles to keep in mind, here are a few other notable items:
- While inflation has been high, the market’s long-term inflation expectations have (thankfully) remained low. This means that markets believe central banks will take the threat of inflation seriously.
- Interest rates have risen relatively sharply, partly due to concerns about inflation but also in anticipation of the Federal Reserve increasing short-term rates, leading to negative returns on fixed income investments. Keep in mind, however, that increases in interest rates actually help long-term investors in fixed income markets by improving the long-run returns we can expect. In other words, for long-term investors in fixed income markets, higher interest rates are generally better than interest rates stagnating at low levels indefinitely.
- While valuations are extremely high for U.S. large-cap growth stocks (stocks with high prices relative to the earnings the companies are generating), valuations for most all other stock market asset classes are much lower. Further, the valuation of value stocks (stocks with low prices relative to the earnings the companies are generating) contrasted to growth stocks is about as wide as it has ever been. Again, diversification across multiple asset classes, I believe, remains important.
In terms of planning, the first thing I would reinforce is that your investment plan is fully cognizant of the fact that markets do decline and sometimes decline substantially over short periods of time. We are well aware of the risk (and expected reward) that investing in global stock markets entails. In fact, over the recorded history of the U.S. market, the vast majority of calendar years have had at least one period where the U.S. market declined by 10% or more and numerous years that experienced intra-year declines of 20% or more, even though, as we know, the U.S. market has gone up more often than it has gone down.
Second, while globally diversified stock portfolios remain risky, global diversification and style diversification can help mitigate risk, especially during periods where broad U.S. market valuations are elevated relative to non-U.S. stock markets and value stocks globally.
Finally, we know that timing the market, tempting as it can be when we start to see markets decline, is extremely difficult. We simply do not see large numbers of individual or professional investors that have demonstrated the ability to successfully time financial markets. To manage the risk of a particular market doing poorly, I believe the better approach is diversification across multiple markets and asset classes, helping reduce the impact that poor performance in any one strategy has on your financial plan.
So, broadly, I encourage you to keep these principles in mind and to continue to remain committed to your long-term investment plan.
1. Return to the Russell 3000 Index from March 24, 2020 – Dec. 31, 2021.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third-party data which may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Indices are unmanaged baskets of securities and are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results. Total return includes reinvestment of dividends and capital gains. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. R-22-3200
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