After 2013, many investors had forgotten that stocks could actually go down. As I wrote earlier, 2013 was very much an abnormal year, where U.S. equities ignored all negative news and rose smoothly throughout the entire year. I cautioned that investors would be wise not to assume this pattern would be repeated in 2014.
After only one month this year, we’re seeing just that. From its peak in early January, the Standard & Poor’s 500 index has declined a little over 6 percent. At the same time, other asset classes that performed poorly in 2013, such as bonds and gold, advanced. Many investors were caught off guard by this reversal but they should not have been. A correction of 6 percent in stocks is anything but atypical.
Since 1928, the S&P 500 has had between three and four corrections of greater than 5 percent per year. A 10 percent decline, though rarer, is still seen roughly once per year. A 20 percent decline, or “bear market,” is seen approximately once every three to four years. These are, of course, averages, and any one year can deviate from the norm, as we saw in 2013.
The question for investors and retirees is what, if anything, they can or should do about this normal level of volatility in the equity markets. The answer to this question depends on both their risk tolerance and where we are in the market cycle and valuation spectrum.
First, determining your risk tolerance is critically important. If you’re the type of investor who panics and sells after every 5 percent decline in the market, equities are not for you. However, if you’re like most investors and can tolerate somewhere between 5 percent and 20 percent declines in your portfolio, an asset allocation plan should be developed to align your equity exposure with your desired level of risk.
In a year like 2013, such a plan might have seemed useless, as U.S. equities outpaced everything else by a wide margin. But again, these types of years are few and far between and one should not be developing an asset allocation plan based on an outlier year. If one did, they would have held 0 percent in equities after 2008 and 100 percent in equities after 2013, which is not an optimal investment strategy.
By adding other asset classes such as bonds, preferred stocks, real estate investment trusts and alternatives, one can lower the overall volatility of his or her portfolio, providing increased comfort during the inevitable stock market corrections. This comfort level is critical for many investors who want to ensure that they don’t panic and sell at the lows, only to return to the market at much higher levels. In short, diversification allows investors to sleep at night and essentially ignore the correction while sticking to their financial plan.
Assuming one has correctly assessed their risk tolerance and equity exposure, is there something more that they can do to avoid and potentially profit from a correction? For many investors, the answer is still no, as any action on their part is likely to be reactive and therefore counterproductive.
But for the more tactical of investors, an evaluation of where we are in the market cycle and valuation spectrum could provide a boost to long-term returns by adjusting their portfolio in advance of a large decline. For example, entering 2014, we are approaching five years into the expansion that began in 2009, and following five consecutive years of gains for U.S. equities. These gains left valuations on the higher end of the historical spectrum, with metrics such as the "price-earnings ratio 10," a smoothed price-earnings ratio made popular by Nobel Prize winner Robert Shiller that uses real per share earnings over a 10-year period, showing a higher valuation than 90 percent of historical time periods.
This is a fancy way of saying that in the “buy low, sell high” axiom, stocks are nowhere near “low” and are much closer to “high.” Historically, this has translated into forward returns being well below average. It is not a short-term indicator by any means but over the next seven to 10 years investors will have to lower their expectations for equity returns.
What can a proactive investor do in response? The simplest response at the end of last year would have been to rebalance, reducing your stock exposure and adding to other asset classes (i.e. bonds) to bring your asset allocation back in line with your desired levels, which are based on risk tolerance.
A more aggressive investor with a patient and contrarian mindset could go beyond rebalancing and seek to overweight alternatives with a low or negative correlation to equities. In doing so, they could further insulate their portfolio from a severe market decline. When such a decline occurs and cheaper valuations are seen, they can then rebalance back into a higher percentage of equities.
These strategies are not easy to implement as you are going against the crowd and the tide of recent performance. However, they are the only proven ways to capitalize on corrections.
Charlie Bilello is the director of research at Pension Partners, LLC. He is responsible for strategy development, investment research and communicating the firm’s investment themes. Prior to joining Pension Partners, he was the managing member of Momentum Global Advisors. Bilello holds a Juris Doctor and Master of Business Administration in finance and accounting from Fordham University and a bachelor’s in economics from Binghamton University. He is a chartered market technician and holds the certified public accountant certificate.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.