Markets Go Up and Down

Volatility has returned to the markets. To keep it all in context, it’s a good time to remind ourselves why we invest and how markets behave. But first, some numbers…

As measured by year-to-date market returns, 2022 has got off to a rather volatile start to say the least. The S&P 500 is off nearly 9%. Small Caps are down even more at nearly 12%. And the Nasdaq 100 (which typifies mostly high-growth technology stocks) is down even more than that, shedding nearly 14% since Jan 1. Real Estate, which was one of 2021’s leading asset classes, is off nearly 11%.

Crypto has also been volatile. Bitcoin is well off its highs of ~$68,000 from last year, settling in around $36,000, almost halving. It is down 20% this year along. Ethereum has fared worse, down more than 33% YTD. Talk of another "Crypto Winter" (like 2018) has ratcheted up. Crypto remains a very volatile asset class.

Meanwhile, bonds are themselves repricing against a new backdrop of a less accommodative Fed (i.e., higher interest rates followed by reducing, then shrinking, the amount of bond purchases) in the face of higher inflation (7% is the latest CPI reading from December). The aggregate US bond market is off by 1.7% since the start of the year as a result (bond prices move inversely to interest rates). That said, the US 10-year Treasury rate sits at 1.77% as of this writing – down from a recent 1.88% just a few weeks ago. Inflation may not be the only driver of rates - markets may be pricing in longer-term factors (i.e., aging demographics, technological innovation, globalization). International bonds are faring only slightly better, off 0.85% for the year.

This week in particular has seen some of the wildest peak-to-trough-and-back daily swings ever. The Russell 2000 index of US Small Cap stocks was down by more than 2.5% yesterday (Jan 24th) only to end the day up 2%. The S&P 500 was even more volatile. It was off nearly 4% around lunchtime but ended the day in the green. So yes, volatility has returned!

What is the cause? Nobody knows, but here a few possibilities (there are others…)

A less-accommodative Fed policy to fight inflation
Post-pandemic growth trajectories
COVID uncertainty
Geopolitics (China, Russia, Ukraine)
Corporate earnings slowdown
Speculative fervor has run its course

While it’s perhaps satisfying to have a view on the “Why?”, it doesn’t actually matter. It just happens, and it will happen again. So, we need to keep in mind that market volatility (both the ups and the downs) is a feature, not a bug, of healthy capital markets. Not since the very early days of the COVID-19 pandemic have we seen such market volatility but looking across longer periods of time we observe many corrections (-10%), bear markets (-20%), and meltdowns (-30+%). We are certainly not sure which way this current market will sway, nor for how long, but we can seek comfort in the data and our core long-term investment principles.

Markets go up and down, perspective is what matters. Volatility is normal, even if it can feel unsettling at times not knowing how far a market can fall (or go up!) before the next turn. Over short periods of time stocks (and sometimes bonds too) can swing wildly. On any given day, stocks are no better than a coin flip. But extend the horizon out 10 or even 20 years, and stocks have proven to generate positive real (net of inflation) returns nearly 100% of the time. So, we invest for the long run and manage our short run with enough cash and bonds to see us through our weekly, monthly, yearly needs.
Diversification is the solution to uncertainty. While concentrated positions in a hot stock or sector can feel great on the ride up, it can be really painful on the way down. A diversified market portfolio will not go “to the moon” as say AMC or GameStop or Tesla had seemed to at one point (and may still do so!), but it will help you reduce the gut-wrenching losses on the way down and it will capture the market returns wherever and whenever they are being generated. Remember, to beat the markets one must not only know when to sell, but also when to buy back in! It is not a winning long-term strategy. Owning a diversified market portfolio removes this systemic risk from our investing lives.
Risk management matters, and never more so than when we experience market drawdowns. It’s best to be honest with ourselves about how much risk we need to take, can afford to take, and are willing to take. Experiencing a few up and down market cycles will help you figure out your true risk tolerance.
Maintaining discipline to an investment strategy that works is the best path to long term wealth accumulation. A “buy and hold” approach requires that you do both, even when markets are falling. This is in fact how we capture higher future returns - through systematic and regular rebalancing of the portfolio. It feels better to buy and sell when you want to, not because you have to.
Tax-loss Harvesting (TLH) opportunities can help. We are always on the lookout for opportunities in clients’ taxable accounts where a security may have declined (but still is an attractive asset class to be in) and can be sold at a loss and replaced with a similar security, simultaneously locking in the capital loss (which can help to offset capital gains in current and future years) and remaining invested.

With the Fed open market committee meeting underway, you can be certain lots of eyes and ears will be tuned to what the minutes reveal about future policy direction. Fed Chairman Powell has indicated that rates are going to start rising and asset purchases will start dwindling and then shrink, all towards the goal of “normalizing” policy now that “full employment” has been achieved (or nearly so). We will learn more details in the coming days but remember that rising (and falling) interest rates are a function of normal Fed monetary policy--as are the reactions by the stock and bond markets to Fed policy. Remember, short-term volatility is normal and healthy, even if unnerving. You are a long-term investor and can tune out the noise and maintain your discipline through it all. Keep on investing!

- Mike