Nov. 2018 – The Stock Market Reversal

The U.S. stock market fell by 6.8 percent in October (all returns cited in this article refer to the S&P 500 and include reinvestment of dividends). As of late November the market remained volatile but had failed to make up any ground. Investors are understandably concerned. But this decline follows an unusually long period of steady gains and reveals little about what lies ahead.

Put it in Perspective

This recent downturn might seem particularly disturbing simply because it has been so long since we’ve experienced anything like it.
Consider that the last calendar-month decline of more than 5 percent occurred all the way back in August 2015. Since early 2016 through this past September, we have experienced 32 months of quite smooth sailing; there were only four months with negative returns, and they were all quickly erased by gains.

Market turbulence meanwhile has been subdued. At the end of last year trailing 12-month volatility hit its lowest point since 1926, and the volatility index (VIX) hit an all-time low. The VIX increased in early 2018, but had fallen again by mid-year.

So in terms of risk versus return, until last month for the most part investors have enjoyed a long period of easy money. But it is these (nearly) three prior years of steady gains, rather than the past two months of decline, that are abnormal. Going back to 1980, losses have occurred in one out of three months on average. In 39 of those months, or roughly once per year on average, the market fell by more than 5 percent.

Recency Bias

There is no reason to conclude that the decline over the past several weeks is a harbinger of a continued decline. We cannot emphasize enough how important it is for investors to avoid “recency bias”, which is the behavioral tendency to assume that recent trends will continue into the future. Consider:

• Since 1980, in those 38 monthly episodes where the market fell by at least 5 percent, the following 12 months provided an average total return of +12.8 percent.

• In the 416 months since 1980 where the market did not fall by at least 5 percent, the following year provided a nearly identical average return of +12.9 percent.

The Latest News

This latest surge in volatility has arrived amidst a backdrop of several worries; a major culprit this time appears to be the threat of a global trade war. Economists have voiced their concern regarding the economic consequences of a breakdown in trade relations and the market has reacted. So, to the extent investors find these worries credible, these concerns are already “priced in” to the market. But there is nothing about this turn of events that suggests the market will (or won’t) fall further.

Whatever happens going forward will depend on new information; in this case news pertaining to the trade front. News, by definition, is unknown. News could break suggesting that trade will be resolved or that it will worsen, but anyone predicting what will happen subsequently is just speculating.

The Takeaway

Unfortunately for investors, many financial service providers are very good at building compelling narratives and forecasts built on information that is already well known. If by chance their forecasts are correct they invariably attribute the result their “skill.” We don’t know what will happen with trade developments or how it might affect the economy in the short-or long- term, and we certainly don’t know how the market will react. But neither does anyone else.

The fact is, stock markets are forward-looking and respond to breaking developments, so the latest trend and old news provide little information with regard to future valuations. Wise investors will be neither distracted nor discouraged by recent circumstances.

Also In This Issue:
Year-End Tax Considerations
Mutual Fund Distributions: Beware of Buying a Dividend
Think Before You Link
The High Yield Dow Investment Strategy
Recent Market Statistics
Dow Jones Industrials Ranked By Yield
Asset Class Investment Vehicles

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