EconomPic had an interesting article about the standard deviation of a 60/40 equity fixed income portfolio having imploded during the bull market and included a great chart for a visual idea of what has occurred.
While I doubt there are any surprises here as you can’t go more than a couple of scrolls on your Twitter feed without seeing something about how low VIX is, it nonetheless raises some good talking points.
The first thing is capital markets are like pendulums with a lot of things. Foreign equities dramatically outperformed domestic in the 2000's. This decade, domestic is way ahead of foreign - until this year. Same thing with currencies, the dollar goes on long runs of outperformance, followed by long periods of underperformance and so on. Where volatility has been low and headed lower this year, it will at some point turn around and move higher. That is not a prediction that I am trying to game so much as an observation of how markets work and a reminder for practice management, take the time to remind clients that market cycles and volatility have not been repealed.
To that point John Hussman’s latest commentary is a doozy. He says that based on his study of valuations versus interest rates and a few other things, he believes that a 64% decline is coming to the S&P 500 (NYSEARCA:SPY) with the expectation that the next 10-12 years will offer negative returns.
If you know who John Hussman is, you know that he has been bearish all the way up. The way I always mention him is to say, he does a great job of framing the bear case, and that is what he is doing; valuations are out of whack given where interest rates are. He hasn’t really drawn the correct conclusion in that he positioned against the market rising and his flagship fund has suffered for it.
If you accept that cycles have not been repealed then you realize that one day Hussman, Jimmy Rogers, and Marc Faber will be correct with one of their respective “markets are gonna crash” calls. This is why investors need the introspection of understanding how good things have been in the market. No matter what you think is going on in the world with anything and for whatever reason you care to believe in, the US equity market has continued to march higher. Maybe that means you’ve been holding your nose while staying long the market, but the market has often done what it shouldn’t and maybe that is what has happened for the entire bull market.
Dialing down the alarm of negative returns for the next 10-12 years, Vanguard is advising its clients to temper expectations, believing that US equities will return 3.5-5% in 2018, a lot less than the 18% and counting in 2017.
Up a lot doesn’t happen all the time and you need to be there when it does like it has this year, if you accept 18% as up a lot. Anyone bogged down in the market shouldn’t be going up to the point that they are overly defensive might be up 5-6% in the equity portion of their portfolio which is a big and unfortunate miss.
I thought of a different way to frame the swirl of indicators all saying different things at any moment in market history. There are things to be concerned about and there are things to act on. The very narrow leadership of the market this year would go on the list of things to be concerned about. Narrow leadership is an unhealthy sign, but doesn’t indicate that the market has turned or offered any timing as to when it will turn. For my money, a breach of the S&P 500 of its 200-day moving average is something to act on in a defensive manner albeit slowly in case of a head fake (whipsaw), the 2% rule tells us that bear markets, as opposed to crashes, give months to get out or otherwise reduce exposure. The 2% rule is something I picked up from Ken Fisher which says that if the market averages a 2% decline, three months in a row then a bear market is said to have started. It doesn’t happen all that often and while you don’t necessarily have to take it literally, look at the previous two bear markets. Six month after their respective peaks, the market was only down about 10%... plenty of time to get defensive. The other indicator that I think is something to act on it an inverted yield curve.
While a crash could come at any time, they tend to snap back quickly or at the very least bottom quickly, the crash of 1987 saw a bottom six weeks later. Bear markets roll over slowly, the next one, whenever it comes will look the same, it will roll over slowly.
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