Market Update: The Elephant in the Swimming Pool


John Micklitsch, CFA CAIA, Chief Investment Officer

The market has started the year with increased volatility, leaving many to wonder what has changed and what, if anything, long-term investors should do. In terms of what has changed, the best analogy we can provide is to think about an elephant jumping into a swimming pool. Only, in this case, the elephant is the Federal Reserve moving off its zero-interest rate policy to help catch up with inflation. Initially when the elephant jumps in the pool, the waves are big, and it can be a little choppy for everybody else. Eventually, though, the waves subside, and the elephant becomes just another swimmer in the pool.

For two primary reasons, we believe the same pattern in the stock market is likely to occur. The first is that, while interest rates may move higher because of Fed actions, we still anticipate they will remain low by historical standards. And second, we believe the economy is still improving, which results in a solid outlook for corporate earnings. In fact, judging from signals like credit spreads, which remain historically tight, the bond market is attributing very little of the market’s volatility to the overall health of the economy, corporate balance sheets or the consumer.

This longer-term perspective, however, does not mean to imply that markets can’t correct further in the short-term. As of Friday 1/21/22, large cap domestic stocks, represented by the S&P 500, are down 6.5%, the tech-heavy Nasdaq is down 12.0% and small cap stocks, represented by the Russell 2000, are down 11.5%. Notably, small caps are down 18.6% from their pre-Omicron variant highs in November 2021. So, they are on the verge of bear market territory (-20%). As we have stated on numerous occasions, temporary market corrections are the price equity investors pay for longer term wealth creation.

According to First Trust Portfolios LP, since 1942, the S&P 500 declines 5% or more three times per year, on average. It declines 10% or more every sixteen months and 20% or more every 5.5 years. The encouraging part of these statistics, according to Ned Davis Research, is that on average it takes the market just 1 month to recover off the lows of a 5-10% correction, about 3 months to recover off the lows of a 10-20% correction and approximately 14 months to recover off the lows of a 20-40% correction. Another amazing statistic, since its inception in 1971 the Nasdaq, which has been the source of tremendous wealth creation and home to some of the most influential companies on the planet, has corrected by greater than 10% sixty-six times in its history. Yet, $1 invested at the Nasdaq’s origin in February 1971 would have turned into $198, by tuning out the noise and letting great businesses do their thing. Adjusted for 3% inflation, that $1 invested in these wonderful businesses would have created a lower, but still mesmerizing, 50-times increase in real wealth.

This brings us to the question, is it different this time? What feels different is the fact that starting equity valuations are high, following decades of mostly falling interest rates. That statement is not meant to imply that there is some sort of cliff out there that investors should try to time as interest rates come off near zero levels. Rather, it is meant to explain and pre-condition that, while still positive, returns measured in five- and ten-year increments, going forward, are likely to be lower than the spectacular returns generated during the last several decades. In addition, volatility could be higher than it has been in the past due to lower trading costs, social media promoting get-rich-quick opportunities and nearly 24×7 news cycles constantly ringing alarm bells.

What should an investor do, then? The long-term answer to that question comes from Warren Buffett, which we’ve paraphrased; Just because there is a new price available for your investment holdings every day, doesn’t mean you have to act on it. You wouldn’t, after all, consider selling your home just because your neighbor is shouting different offers over the fence at you daily, so why should your long-term investments be any different?

There are of course steps we can take, beyond maintaining a long-term perspective, that can be helpful in times like these. The first step is to have a personal liquidity bucket of capital set aside so that you do not have to touch your investments for spending needs at inopportune times, such as during a market correction. For those who are presently working and still producing income, three to nine months of liquidity needs can suffice, although personal preferences and larger, planned expenditures can impact that figure. For those relying completely on their investments for income, that figure might be more like twelve to eighteen months of reserved liquidity, depending on your feelings about risk.

The second step an investor can take is to look at their asset allocation. We have long hailed the benefits of diversification and holding quality assets. Once those two criteria are taken care of, the investor’s primary job is to remain optimistic about the future and focus on time in the market and not trying to time the market. On the topic of asset allocation, however, we encourage investors to consider holding some value and international diversification in their portfolios. In addition, investors can examine the weighting of their fixed income holdings closely in the current low (but potentially rising) interest rate environment and consider volatility-managed alternative investment strategies that can add return potential relative to bonds, but without introducing additional equity risk into the portfolio.

Your Ancora team is experienced in all these concepts and strategies and can discuss suitable adjustments, if any, that you might consider in your long-term investment plan. We look forward to our continued partnership with you as we work together across this ever-evolving investment landscape.

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