Risk Makes a Comeback

Monday brought volatility back to the forefront of everyone’s minds in a jaw-dropping 1,000 point pullback.  This was the biggest point pullback ever. That type of headline will get anyone’s attention.  However, it is also a pullback that started from a Dow at the highest level ever.  As the level gets higher, the point pullbacks get higher.  To put it in perspective, while the point drop is indeed staggering, the percentage drop (about 4%) is not necessarily as bad on a relative basis.  In fact, there have been 107 worse days in the market than Monday ended up being.

There are several reasons why this could be the beginning of the end for the stock market’s great run, namely:

  • We’re due – It’s been so long since the last pullback, we need a correction.
  • The market is overpriced – On a price-to-earnings basis, the market in the US is overvalued and should adjust back down towards its long-term average.

However, there are also several arguments on the other side that can point to this pullback just being temporary:

  • Earnings have been strong – We just came across an earnings season that had wonderful results, meaning corporate profits have been more or less keeping up with market growth.
  • The economy is doing fine – The US will likely see 3% growth this year. That’s a healthy clip.
  • Global diversification is cheaper – While we in the US might have price-to-earnings ratios that are a little high, a diversified portfolio can tell a different story. Developed international stocks look fairly valued and emerging market stocks can still be considered cheap.
  • Look at the bull market – Bull markets are full of head fakes. Will a 5% drop turn into a 10% drop?  Will a 10% drop turn into a 20% drop?  Or, will the market shrug it off and come rallying back?  This market has been full of events that could have broken the back of this bull market but didn’t.  To name a few, think of the US debt downgrade, Brexit, and the flash crash.  This could be another one.

The volatility that has come back to the market reminds investors of one thing.  The markets are never a spot with all reward and no risk.  Last year we were spoiled by fantastic returns that carried with it the risk of a harmless bond.  That is not normal.  Neither are 1,000 point days.  However, volatility is normal.  Each and every year the market on average falls 14% from its high point in a year to its low point.  While that isn’t pleasant, it is expected.  And despite that type of downturn, the majority of the years end up positive.  To get the good returns that stocks give over time, we certainly have to be willing to put up with that, as well as the occasional outsized down day like Monday.  The important thing to remember is that there is absolutely no way to know whether this big down day is the beginning of the end or just a blip on the continued ride up.  That makes your balance of stocks and bonds as critical as ever to be right for you for whatever type of market we head into.

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