ETF Store Insight

Investors’ Two Best Friends: Time & Diversification

January 15th, 2019 by Nathan Geraci

Nathan Geraci is President of The ETF Store, Inc. and host of ETF Prime.

After hitting record highs on September 20th, the S&P 500 dropped 20%+ through December 24th.  A less than spirited holiday week bounce only somewhat salvaged the carnage.  Up 11% late into the 3rd quarter, the S&P 500 ended 2018 down 4.5%.  The swoon ended a streak of 9 consecutive years of gains following the global financial crisis, tied for the longest such streak in history.  The contrast between the first three quarters of 2018 and the fourth was stark:

Source:  Tim Edwards, S&P Dow Jones Indices

 

U.S. stocks weren’t alone in their misery.  International stocks fared even worse, with both developed market stocks and emerging market stocks declining approximately 14%.  Most sectors of the bond market – typically an investor refuge – also fell as rising rates pressured prices (interest rates and bond prices move in opposite directions).  Stocks, bonds, real estate, commodities – there was nowhere to hide in 2018.

Source:  JPMorgan

 

The challenging market environment was blamed on a host of factors including an overly aggressive Federal Reserve, trade tensions, political turmoil, and evidence of a global economic slowdown.  In the U.S., debate now centers around whether a recession is on the horizon.  Stocks are generally forward-looking indicators, and a 20% down move (arbitrarily defined as a bear market) has some wondering whether stocks might be trying to tell us something.  Unfortunately, historical data proves inconclusive with only 7 out of the last 14 bear markets resulting in a recession.

Source:  LPL Research

 

Another more reliable predictor of economic recessions is the yield curve.  Every recession since the 1950s was preceded by an inverted yield curve, where longer-term U.S. Treasuries yield less than shorter-term U.S. Treasuries.  Investors loaning money for a longer period of time expect compensation in the form of higher interest rates.  When shorter-term rates are higher, it signals concerns about future economic growth.  The yield curve came close to inverting during the 4th quarter, though has yet to do so.  The problem with reading yield curve tea leaves is that even if there is an inversion, stocks can still continue posting strong gains.

Source:  The Wall Street Journal

 

Time will tell if the economy is heading for a recession.  In the meantime, some context is important for longer-term investors.  The S&P 500’s 9-year win streak featured average annual returns of nearly 16%, far higher than the historical average of around 10%.  It’s entirely natural for U.S. stocks to pause and catch their breath.  There is a reason the 9-year bull run tied for the longest:  it simply doesn’t happen.  Down years are inevitable.  The longer-term rewards of stocks aren’t provided free of charge.

International stocks are no different.  While the relative underperformance versus U.S. stocks has been frustrating, international stocks have proven their mettle over longer time periods.  So too have bonds, a time-tested portfolio ballast.  While rising rates may cause short-term pain for investors, they can be beneficial over the long-run.  Rising rates equate to greater income for investors, and that growing income ultimately exceeds shorter-term capital losses for investors with longer time horizons.

Two key takeaways after a year like 2018 are 1) Recognize your time horizon, and 2) Embrace diversification.  Time is your best friend on the path towards achieving your financial goals.  Diversification helps keep you on that path.  Owning a globally-diversified portfolio including international stocks and bonds can improve your overall risk-adjusted returns.  You will never own 100% of the best performing asset classes and, consequently, you will never be over weighted in the worst.  Expect the steady stream of headlines to continue in 2019 – trade wars, Brexit, North Korea, political showdowns, the Fed – but sleep soundly knowing that time and diversification are under your pillow.