Investing During Adversity

The return of volatility to the stock market has many presumed and logical causes, including:

  • Slower earnings growth
  • Rising interest rates
  • New U.S. home sales near a three-year low
  • A sharp slowdown in economic growth in China (more on that in a moment)
  • Trade wars without an end in sight
  • Nine years without a negative annual stock market return – until 2018

Any one of these factors – and countless other unknown risks – could cause stock prices to remain on a downward trend this year. Meanwhile, the volatile path we’ve lately traversed seems almost certain to persist. To wit: Last year was the most volatile for the S&P 500 index since 2008, including five days where the index moved at least 4%, and about five dozen days of at least 1% swings.

This choppiness reared its angry head even while the U.S. economy is growing strongly, unemployment is low, and manufacturing is expanding. Imagine if these factors were worsening. And now be ready for a revelation.

For as rocky as 2018 was, last year’s volatility was actually just a return to something much closer to normal – or average – annual volatility. That’s right: Historically, last year was a much more typical year for prices than were the years of 2010-2017.

That 2018 felt volatile at all – let alone garnered so many headlines – gives you a sense for just how accustomed many have become to an overly-calm stock market. Unfortunately, you should probably say goodbye to the atypical calm, and need to brace yourself for much more typical volatility from here forward – especially if (or when) the U.S. economy starts to weaken.

Someday we’ll of course enter another recession. Nobody can predict when that will happen, or which confluence of factors will lead to it (especially in today’s interconnected world), but we know it will happen. So, what can investors do about it?

Investing for Adversity

In trying to assess where we stand and how much risk investors may face, many fingers point to the projected valuation of the broader market. Lately, S&P Global Market Intelligence estimates that the S&P 500 index companies will earn nearly $172 in normalized earnings per share (EPS) in 2019.

Lately around 2,580, the S&P 500 index trades at about 15 times that earnings estimate, which is nicely aligned with its long-term historical median and mean P/E average. However, the 2019 EPS estimate suggests about 9.5% earnings per share growth over 2018 levels, which could prove too robust. In other words, we can’t bank on projections to protect us from risk, especially when we know that Wall Street analyst projections are wrong more often than right! And risk is, after all, what occurs when the unexpected occurs.

Approaching the millennium, investors couldn’t be much more optimistic about stocks and earnings estimates. The roaring ’90s and the rise of the Internet promised unbounded growth for years to come. Instead, from the S&P 500’s March 24, 2000, peak of 1,527, investors had to wait all the way until 2013 to both pass that level again and to (so far) keep the gains. (The S&P 500 did fleetingly move above the 2000 peak right before the Global Financial Crisis.) For 13 years, the index went nowhere. The Nasdaq Composite required more than 15 years to regain its March 2000 peak, doing so in April 2015.

Before then, the 1970s were another good reminder that stocks can be flat for years – a decade or longer.

A look at how long it took the S&P 500 to permanently move above its 1968 and 1973 market peaks.

And even when the market rises, it doesn’t always provide stellar returns. The S&P 500 has gained a relatively modest approximate 70% from January 1, 2000, to December 31, 2018. So, index investors have not truly been well rewarded for all the risk they’ve taken in equities during a very rocky 18-year period. Let’s not kid ourselves – the Great Recession could have changed everything for all of us, financially, and unfortunately did for millions. Right now, we’re fortunate to have the returns we do have. But has the financial world learned its lessons? Does human behavior change?

A Shifting World Landscape

Assessing risk as we look forward, we have to admit that a great deal of exposure to it now comes from outside the United States. S&P Global Intelligence data estimates that 43.62% of sales at S&P 500 companies was earned outside the United States in 2017. The United States is still the world’s largest economy, but of course its population is dwarfed by other countries, and sales to those countries are growing. For American investors to assess risk, they need to be watching all major economies now, not just the U.S.

Soon, the U.S. won’t be the largest economy any longer. Standard Chartered research estimates that, by 2020, China will surpass the U.S. economy as the largest when measured on purchasing-power-parity exchange rates and nominal gross domestic product. And by 2030, India is anticipated to surpass the U.S. economy in size, too, and the U.S. is not likely to regain its top dog status in our lifetime. So, we may be witnessing the end of an era, and it has broad implications for investors.

Next week, we’ll talk about one’s investing approach in light of today’s realities:

  • We face greater risks in 2019 and 2020 than we ended up seeing the past many years
  • We are perhaps exiting a long economic expansion with the federal government sporting a much weaker balance sheet and deficit, tax rates already lower, and with low interest rates – all the opposite of what you want toward the end of an expansion, leaving the government fewer ways to help in a recession.
  • The investing landscape is changing as more volatile foreign countries drive ever more of the S&P 500’s sales.

Next time, we’ll talk about portfolio strategies to stay invested and target returns despite the risks, while keeping risks in check, too.

Enjoy your week!

—Jeff Fischer

The content in this message is provided for informational purposes only, and should not be relied upon as recommendations or investment advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.

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