Third Quarter 2014 Letter to Clients

After a long run of smooth sailing for stocks, volatility returned to the markets in a significant way during Third Quarter 2014. Daily swings in the Dow Jones Industrial Average of 200 points or more have become commonplace in recent weeks.

As we mentioned in this space a few months back, point declines are very much relative to where the market is. When the Dow is at a level of 17,000, a 200-point drop is actually a fairly modest decline, amounting to a percentage drop of only 1.2%. This won’t stop the media from trumpeting the news that stocks suffered a “huge selloff” on the evening news, of course, so it is important for investors to keep this in perspective.

None of this is to deny, however, that the “fear” gauge is trending higher in the market and stocks are experiencing more dramatic swings as a result. When we consider the geopolitical landscape, it’s not hard to understand why. We thought this screen capture from a recent bit on The Daily Show on Comedy Central summed it up nicely:

It seems that way lately, doesn’t it? From the rising threat of terrorism in the Middle East to the potential Russian invasion of the Ukraine to fears of a global Ebola pandemic to riots from Missouri to Hong Kong – trouble seems to abound all over the globe. The list of anxieties for investors today is a long one.

Because no one knows how global events are going to resolve themselves, their impact on the market is impossible to assess ahead of time. In the late 1990s, the Y2K computer bug was thought to be a huge threat to the economy and, correspondingly, to the stock market. Instead it was a complete non-event for investors. On the other hand, what started out as the relatively benign “subprime mortgage crisis” in late 2007 blossomed into the Great Recession a year later and tanked the stock market in October 2008.  

As investors, we all wish we knew ahead of time which events will impact the market negatively and which won’t, but no one has that crystal ball. The talking heads in the media want us to believe they do; they love to give us scenarios and suppositions because that’s how they get face time on the networks. But the truth is they don’t know any more than you do. Any guesses about how events will turn out are just that – guesses.

For the sake of discussion, however, let’s consider those times when events do negatively impact stocks in a significant way. In the midst of these events, fear can be overwhelming to investors, and the desire to run for the exits becomes acute. For example, in the wake of 9/11, it didn’t take a financial whiz to know that the stock market was going to plunge when the New York Stock Exchange reopened. And it did: The Dow fell more than 7% on September 17, the first trading day after the attacks. 

The problem with trying to avoid these types of downturns is that, by the time the impact of such events becomes clear, it is too late. The market begins pricing in those impacts immediately; investors who bail out at that point are only locking in losses. It is the equivalent of frantically selling your house after property values decline 20% in your area.

The good news for those who have the fortitude to stay put is how quickly stocks historically recover from sudden downturns. For example, when the Dow plunged more than 20% in just a few weeks’ time in 2011 following the downgrade of the U.S. credit rating, the market fully recovered those losses by the end of the year. 

Even the mother of all modern-day stock downturns – the 2008-09 bear market – wasn’t that bad for that long. Though the Dow hit a low of 6,443 in March 2009, it was back over the 10,000 level by the end of the year, and it was back above 12,000 in early 2011 – its pre-Lehman level in 2008.

This is not atypical for how the market responds to crisis; in fact, it is typical. The following chart shows the returns of a balanced 60% stock / 40% bond portfolio in the one-, three- and five-year periods after some of the major events of the past thirty years. (Courtesy of Dimensional Fund Advisors)*: 

After a big downturn, the market begins its recovery suddenly and significantly. The majority of the gains earned in a bull market come in the first weeks and months after the prior bear market ends. Investors who try to time the market and avoid downturns usually end up locking in some or all of the losses on the front end and missing some or all of the recovery that follows.

It is interesting to note that every triple-digit drop in the market in recent weeks has been followed by frenzied buying. It’s not hard to understand why. There remain many thousands of people sitting on cash who bailed out of the market in 2008 and 2011 who have watched the market pass them by and are desperate to get back in. Now they are having to pick their poison. Do they buy back in at elevated levels and run the risk of catching a downturn? Or do they stay on the sidelines and potentially watch the market climb even higher?

This is the dilemma that paralyzes those who try to avoid downturns in the market. Those who stay invested, happily, are never confronted with it.

* * * * *

When markets become more volatile, asset classes perceived to be riskier decline more than those considered to be safer. Stocks decline more than bonds, small stocks decline more than large stocks, etc.

That was certainly the case in the third quarter, when we saw large U.S. stocks post the only gains of the major equity asset classes.

The small cap asset class, in particular, was hard hit, with the Russell 2000 small stock index declining 7.36% for the quarter. This is a relatively modest decline, however, in light of the tremendous gains that asset class has enjoyed since September 2011:

Most investors consider “the market” to be the Dow, because that’s what they see on the news every day. But the Dow is only one part of one asset class; the largest of the large cap U.S. stocks. When those stocks lead the market, it can seem that diversification isn’t providing much benefit, particular when other asset classes post declines. It’s important to remember, however, that every asset class has its day in the sun and its day in the cellar. Diversification is about smoothing those extremes over the long term, regardless of which asset class is leading the market in the short term.

*Balanced Strategy: 7.5% each S&P 500 Index, CRSP 6-10 Index, US Small Value Index, US Large Value Index; 15% each International Value Index, International Small Index; 40% BofA Merrill Lynch One-Year US Treasury Note Index. The S&P data are provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2012 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. CRSP data provided by the Center for Research in Security Prices, University of Chicago. US Small Value Index and US Large Value Index provided by Fama/French. International Value Index provided by Fama/French. International Small Cap Index compiled by Dimensional from Style Research securities data; includes securities of MSCI EAFE countries in the bottom 10% of market capitalization, excluding the bottom 1%; market-cap weighted; each country capped at 50%; rebalanced semiannually.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance.