“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” – Peter Lynch
Third Quarter Recap
The third quarter provided a study in contrasts, with news headlines and equity market returns continuing to diverge. On the news front, North Korean continued to threaten nuclear action, the White House thought it wise to take on the NFL, and natural disasters struck Texas, Florida, and Puerto Rico. Conversely, U.S. and international stock markets seemed to ignore the headline du jour, and closed the month of September with very strong YTD returns.
The S&P 500 closed the month with a YTD return of 14.24%. International stocks, measured by the MSCI EAFE Index, have returned 20.47%, YTD, through the end of September, while emerging market stocks have returned 28.14%, YTD. Bonds, as measured by the Barclays U.S. Aggregate Index, have returned 3.14%, YTD, as the Federal Reserve has kept interest rate policy relatively loose and longer dated bond yields have fallen.
With geo-political headlines peppering the press and equity markets coming off three straight quarters of very strong performance, it is easy for investors to cast a wary eye toward the stock market and wonder if the next move might be lower. The financial media website MarketWatch recently highlighted that the current bull market in stocks is the second strongest bull market since World War 2. Goldman Sachs recently noted that the market has gone over 300 days without a 5% correction or pullback.
As many equity indices have returned over 10% this year, and seemingly little volatility has surfaced, what is a prudent investor to do? In short, nothing. By nothing, of course, we mean stick to a diversified investment approach, which does not bet only on U.S. stocks going up and down, but also actively incorporates other investments, such as international stocks or bonds, which may offer more compelling long-term return opportunities than U.S. stocks.
Investors should also know that market corrections occur with frequency and are a normal part of the investing experience. The sole fact that the market has gone an extended period of time without experiencing a correction (as seen in the chart below) does not necessarily mean that the next drop will be severe, nor does it mean that it is imminent.
Rather, the more important lesson is that if one is investing for the long-term, and is buying quality businesses with favorable valuations, attractive yields, and reasonable balance sheets, a garden variety correction of 5, 10, or even 20% should not be overly concerning.
You can see in the chart above that corrections are a regular feature of the equity market. In 2010, markets fell 16%. To look a little closer at the context of that drop, this was just a year removed from the financial crisis and a major recession. The word’s “double dip” (a reference to a second potential recession) were played out in the financial media. If one had overly worried about the correction that was going on, rather than keeping a long-term mindset with their equity investments, they would have missed out on tremendous upside. When investing, discipline pays off, both literally and figuratively.
Another key area of focus for the markets is the Federal Reserve. We have noted in prior commentary that we do not expect the Fed to aggressively hike interest rates, as inflation remains tame and they have little desire to upset equity and bond markets. However, the Fed has started to signal that they may hike rates faster than what the market is expecting them to do.
A month ago, there was little expectation the Fed would hike rates again this year. However, as of the end of September, CME Federal Funds futures (a contract that is used to predict the odds of a rate hike) now estimate a 74% chance they will hike rates in December. If the Fed does move faster than expected, it could create pressure within bond markets. As a result, we have been actively positioning our fixed income portfolios towards floating rate securities which have minimal interest rate risk, as well as shorter maturity municipal holdings that offer attractive yields along with low interest rate risk.
In closing, we want to remind investors that corrections within investment markets are a feature, not a bug, and, as the great investor Peter Lynch notes, are not something to lose sleep over. From our perspective, the lack of a correction in U.S. stocks merely enforces our portfolio decision to incorporate a greater degree of international and emerging market stocks, which have more attractive valuation characteristics and greater earnings upside. Lastly, though the Federal Reserve is looking to raise rates, we believe diversification within fixed income will help mitigate the risk of rising rates.
Investment Advisory services offered by Independent Financial Partners (IFP), a Registered Investment Advisor. WhartonHill Investment Advisors and IFP are separate entities. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
 All return data from Morningstar and JP Morgan as of 9/30/2017 unless otherwise noted.