4th Quarter Client Note – Is Past Ever Prologue?

By Steven Smith | Waypoints

Jan 15

The S & P 500 (total return) Index fell 13.52% in the 4th quarter, bringing the benchmark index to a loss for the year of 4.38%. This, following a best-quarter-in-five-years gain of 7.2% in the 3rd quarter. The negative 9.03% in December was the 11th worst month in the past 50 years. The three worst months in the past half-century were: October 1987 (-21.54%); August 1998 (-14.46%) and October 2008 (-16.79%).

Nowhere to Hide

If the negative returns in the US markets weren’t bad enough, global diversification provided no backstop in 2018. The MSCI Developed Market Index fell 12.54% in the quarter and 13.79% for the year. The MSCI Emerging Markets Index fell 7.47% in the quarter and 14.58% for the year.

But for a good explanation of why investing globally over the long term is so important, see the essay on “Why You Should Diversify” in the Quarterly Market Review from our friends at Dimensional Funds Advisors. We are reminded there of the “Lost Decade,” from 2000 – 2009, during which the S & P 500 delivered a cumulative total return of -9.1%, while international developed markets delivered positive returns and emerging markets packed a considerable punch.

All of the riskier, return seeking asset classes were down for the year. US Large Cap Value (-8.27%); US Small Cap Value (-12.86%); US Real Estate (-4.22%); Commodities (-11.25%).

Fixed Income

The Barclays US Aggregate Bond Index rose 1.64% in the quarter and eked out a 0.01% gain for the year; despite four Federal Reserve rate increases in 2018. There have been mixed signals on whether the Fed will continue its stated goal of raising rates into and throughout 2019. Stay tuned.

Critically, an allocation to fixed income softened the blow in 2018 for balanced portfolios. A representative 50/50 portfolio fell 3.49% for the year. More importantly, a globally diversified, multi-asset class portfolio over the long-haul not only suffers less during market sell-offs, but generally produces a sufficient return for investors to achieve their long-term goals.

Back to Normal

While 2018 may have seemed like an extraordinary year for volatility. It wasn’t. The CBOE Volatility Index (VIX) averaged 16.6 in 2018, the 12th lowest level since 1993. By comparison, the average in 2017 was 11.1. 2017 was the only year in history that market was up every single month. Human nature makes it extremely difficult to put market gyrations in perspective. But we must. The averages in the market are like temperature averages. The average temperature in Denver is 50°. But that’s only because the average high in July is 88° and the average low in January is 17°.

Looking Back on the Financial Crisis of 2008 – 2009

With the more intense volatility upon us, it may pay to reminisce on some fairly recent – and unforgettable – history, to see if there are any lessons to be learned. In a previous post I discuss some of the lessons of the Bernie Madoff Ponzi Scheme that was unearthed during the crisis.

Ten years ago we were in the midst of the second worst bear market in history. The worst being the one that started with the crash of 1929. Between November 2007 and March 2009, the S&P 500 Index fell 54%.

It was a perilously uncertain time for the global economy – and for investors. There was a cluster of causes of the underlying calamity. But the main cause was the extension of billions of dollars of credit to home buyers who turned out not to be credit worthy and the securitization of those home mortgages throughout the global financial system.

No one really knew the depths of the crisis or whether government policy prescriptions would work to resolve it or how long that might take. And in the US – with President Obama being elected in November 2008 – there was a change of administrations right in the middle of it.

Some of the fallout remains to this day. The Federal Reserve lowered interest rates to near zero, kept them there for years and has just recently begun to normalize rates as the economy has reached full employment.

For investors with a plan – and a long-term time horizon – the lesson, although difficult and painful, is reasonably clear. Don’t panic. The March 2009 bottom represented the beginning of one of the longest bull markets in history.

Some Longer Historical Perspective

Sometimes it helps to put things in an even longer historical perspective. In this recent blog, Jared Kizer, Chief Investment Officer at Buckingham Strategic Wealth shows 21 other quarters in which the S&P 500 Index marked a return equal to or worse than the fourth quarter of 2018. In five instances the next quarter’s return was negative. In 16 cases the following quarter’s return was positive. The average 12-month return following these quarters was 22%. Of course, there is no way to know what 2109 will bring.

But here’s the thing: If it weren’t for equities’ frequent bouts of volatility and drawdowns (top-to-bottom losses), there would be no reason for them to outperform bonds and cash in the long run.

Ain’t Nothing Like the Real Thing Baby

Marvin Gaye & Tammi Terrell had it right back in 1968. As part of our portfolio planning, we advisors administer “risk tolerance” assessments. Research and technology have made them more accurate over time. But much of it is just hypothesizing around how we would behave during market turmoil. So tell me about your risk tolerance. Well, what if you’ve never been through a bear market before, how the heck do you know? Some investors successfully lived through 2002 and 2008. Some didn’t. Some weren’t yet investing. Some forget how bad it was.

 

Emergency Broadcast System This is only a test

For some, a market correction is just a test. For others, it’s an actual emergency.

 Avoiding Panic Selling

Clearly the goal is to avoid panic selling. Hysterical selling is almost always a consequence of taking on too much risk in a portfolio. And it is never a good idea, because there is no all clear sign to tell you when to get back in. And it will implode your plan, assuming you had one.

We have no idea whether we are entering a bear market, extended or otherwise. Recent events provide no clue. Economic and market forecasters have a terrible track record. Talking heads on TV explanations of why the market went up or down on a certain day are fantasy. Relying on them – as opposed to adopting a strategic asset allocation – makes little sense.

And, of course, you need to have an asset allocation strategy that matches your time horizon and your need, desire and ability to absorb risk. Maybe it is the right time to dig back into your formal, written plan and make sure you are still on course to ride out a bear market. And even though there is no accurate way to make short-term market forecasts, that’s not to say you shouldn’t have some reasonable expectations of what your returns might be over the course of your investing time horizon. Longer term capital market assumptions are generally more reliable.

And have a cash or short-term bonds buffer to make sure you don’t have to sell equities during a downturn for living expenses. By all means, get some help if you need it.

Managing Our Emotions

There are plenty of things to worry about. There always is. I won’t catalogue the current ones here. You know what they are.

But we need to let our emotions do their thing; coursing through our minds and bodies. Fear and loss aversion (the tendency to value losses more than equivalent gains) are hard wired into our beings. We can’t help but feel how we feel. But then, at least when it comes to investing, we have to put aside our emotions – especially fear – and follow or well thought out, long term plan.

John Bogle is famous for his aphorisms: “Stay the Course” and “Do Nothing.” But these only apply if you have a long-term plan. I love this blog entry from British investment advisor Joe Wiggins, 50 Reasons Why We Don’t Invest for the Long-Term. See if any of them apply to you.

Here’s another tip: Don’t look. I know that’s hard. But research has shown that investors who check their portfolios frequently tend to behave as though they have a short-term planning horizon – and consequently make mistakes.

IRA/RMD – Silver Lining

There had to be a silver lining in all this. As a result of one of the worst Decembers ever, those of you taking required minimum distributions (RMD’s) from your IRA’s – either because you are 70 ½ or because you have inherited one – will have a smaller distribution. This is because the RMD is calculated on the December 31 account balance.

Count your blessings in the New Year!

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