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Equity Perspectives

What should investors be thinking about amid the heightened market volatility?

After months of relative calm, volatility returned to the stock market in a big way on October 10, with major U.S. equity indexes sustaining losses of greater than 3% on the day. Interestingly, while the Dow Jones Industrial Average’s 832-point drop was its third largest ever in point terms, its percentage drop of 3.1% was only the 80th biggest such decline since the 1950s, according to Nestor Melendez, an equity trader for Lord Abbett.

What drove the selling? The catalyst often cited by market observers was the rising interest-rate environment (U.S. Treasury yields have risen 77 basis points year-to-date through October 10), followed by pronounced weakness in the technology sector, the one-time market leader. Melendez believes this could reflect a rotation from growth to value shares, though value shares were also under pressure during the session.

Market structure also came into play, Melendez believes, pointing to a blackout period for corporate stock buybacks, contributing to an absence of buyers. Plus, major indexes moved below certain key technical levels (for example, the Dow Industrials closed below their 50-day moving average).1 Finally, Melendez thinks global developments were also a factor amid persistent concerns about Brexit, Italy’s fiscal situation, and the U.S. trade conflict with China.  A reduction in the global economic growth forecast by the International Monetary Fund may not have helped matters.

“None of the factors specifically explains the equity smackdown on October 10—but in totality, it makes for a messy picture,” Melendez says.

While it’s important to understand the factors that drive short-term market movements, we believe it is critical to maintain a longer-term perspective. With that in mind, here are three points to consider as you’re watching financial news programs or scanning market-data websites for the latest developments in the coming days.

1. Big market drops are normal, and don’t always translate into full-year losses.

As tempting as it may be for investors to flee the stock market during times of market volatility, a decision to do so may prove costly in the long run, and disregards counsel to stay invested for the long term, as history provides. In short, the volatility we are currently experiencing is a normal part of long-term investing, as Chart 1 shows. Equally important, these big declines have not normally signaled market losses for the full calendar year.

Chart 1. Drawdowns Have Been Common, But They Haven’t Always Translated Into Full-Year Declines
S&P 500 annual price returns versus maximum price decline, as of December 31, 2017

Source: Morningstar.
Note: The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 
Past performance is not a reliable indicator or guarantee of future results.

 

Intra-year, and year-over-year, returns may have been up or down, but over the long term, we believe investors who stayed invested demonstrated a sounder strategy for potentially realizing gains in the equity markets. 

2.  Fundamentals remain strong in the United States.

We covered this theme in a recent Market View examining the investment implications of the U.S. midterm elections, but it bears repeating here. Regardless of events elsewhere, the investment environment in the United States is currently characterized by:

  • Double-digit overall corporate earnings growth
  • Consistent economic growth, which has remained above 3%
  • Well contained inflation, which has remained in line with the U.S. Federal Reserve’s target of 2%

But what about rising interest rates? As Lord Abbett Partner and Director of Strategic Asset Allocation Giluio Martini notes, the recent modest rise in interest rates, which would be negative for stocks taken by itself, is “being overwhelmed by strong earnings growth.” He adds that while the U.S. tax bill passed in December 2017 was widely expected to have a positive effect on earnings, expectations of growth at 15%-17% were eclipsed by reported growth of over 20%. This stronger growth meant that forward earnings valuations (based on market levels as of early October) were close to long-term averages, and not stretched to unreasonable levels by the market’s gains earlier in the year.

3. Normal volatility may represent a good entry point for equities.

Historically, when the market experienced a volatility spike against the backdrop of a strong economy—regardless of the catalyst—equities tended to regain their footing relatively quickly after a daily decline in the S&P 500 Index of 3%-6%, and typically were stronger three, six, and 12 months down the road, based on research from Morgan Stanley.2

Short-term returns may be mixed, but over the long term, spikes in volatility historically have represented a buying opportunity when the fundamental backdrop is as strong as it is today.

A Final Word
Simply put, we believe uneasy times can be great times to invest. Unfortunately, investor behavior is often ruled by emotion, leading to panicked decisions and investor returns that lag asset returns.

Arguably, the most important thing we believe that financial advisors can do for their clients is encourage them to stay invested. Advisors typically can provide a long-term allocation plan that includes regular rebalancing, and access to experienced investment managers who have navigated past periods of volatility.

 

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