For quite some time we have been writing about the fact that a host of data continue to suggest that weaker conditions in the U.S. and global economy are spilling over into the financial markets. Today, we saw more of the same in terms of the 7% drop in oil prices, the S&P 500 breaking into correction territory and weaker manufacturing PMI data. Rather than harping on the doom and gloom drum, we think that investors can take a few proactive measures as data continue to deteriorate and the outlook for the markets look becomes more mixed.
We’re not calling a bear market (yet)
First of all, it is important to note that we are not calling a bear market in stocks or an imminent recession just yet. Rather, we believe that there is a potential that markets could indeed attempt a rally through the end of the year as positive developments in Italian debt, Brexit and U.S.-China trade negotiations lead to a relief rally.
Our outlook is nonetheless based on the fact that a host of data are pointing to a general weakness in the broad economy. Indeed, this outlook is held by a host of economists forecasting slower economic growth in 2019 compared to 2018, weakness that is expected to persist into 2020 when the likelihood of a recession is expected to be higher than today.
Historically, the stock market has tended to lead (not lag) a recession, beginning with wider and wider market gyrations that eventually give way to a full-blown bear market. This happened in 2007 and 2008 before an eventual capitulation in the markets in the fourth quarter of 2008. We believe this has to do with markets being forward-looking discount mechanisms which tend to price in weaker corporate earnings growth as expectations of economic activity deteriorate, for which markets expect commensurate price compensation (cheaper stocks).
How to prepare for a market downturn
From this vantage point, what is an average investor to do and how can they prepare for a broad selloff? We believe that there are generally three things that investors can do to prepare for a potential turn in the markets: 1) rebalance, 2) refrain from timing the markets and 3) continue dollar cost averaging.
First, the temptation to chase individual asset performance (like making the decision to cut winners and keep losers in isolation) at the expense of the broader portfolio can be detrimental to long term investment returns. The asset performance quilt chart posted at the top of this article illustrates that over time, various asset classes tend to outperform their peers in different periods of time. In other words, this year’s outperformer may be next year’s underperformer. Further, the chart shows that a diversified asset allocation-based portfolio tends to maintain its moderate relative rank regardless which asset class may be outperforming in a given year.
Second, attempting to time the markets can hinder, not help with long term performance returns. Studies have shown that some of the best performing days in the markets tend to happen shortly after some of the worst days in the market. Attempting to time the markets means that an investor must know with some precision when the emotional aspect of the markets will contribute to eventual capitulation, bottoming and a subsequent rally. Selling out of the market at the bottom (instead of staying put through the volatility) means that an investor will need to pay more when rebalancing your portfolio as markets rally, dragging down portfolio performance.
Finally, sticking with a mindful dollar cost averaging practice during periods of market volatility can provide practical and psychological benefits. From a practical perspective, the act of contributing a fixed dollar amount to a portfolio during a downturn means buying assets when they’re cheap with the expectation of prices moving higher as markets rebound. From a psychological perspective, the act of buying into market volatility can provide investors a sense of validation and commitment to a long-term investment process. This can ultimately provide an invaluable sense of reassurance during a period of heightened market uncertainty.