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Keeping Recent Volatility in Perspective

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Investors get worried when we see market pullbacks of 5%. I get it, no one likes to see the market go down.

I think concerns over a market pullback are particularly heightened right now based on a combination of different issues in the news like:

  • Continued concerns over COVID
  • Slowing global growth
  • Potential tapering by the Fed
  • Ambiguous fiscal policy
  • Government shutdown and debt ceiling worries
  • Potential risk from China’s property sector

Add to this that we have seen really strong year-to-date gains and it’s easy to see how an amplified sense of urgency has been created to “do something” (i.e. sell or hedge).

So let me take a step back and put some of these developments into perspective.

We think the underlying fundaments in the market remain supportive. Now I know that sounds like finance “blah blah blah,” BUT, it’s looking like the latest wave of COVID has peaked…and while, yes, winter is coming, each wave does bring higher levels of public immunity along with continued vaccinations.

Corporate earnings remain supportive. It’s looking like earnings will have a 50% growth rate year-over-year and will be 20% above 2019 levels (my attempt to factor out the trough of 2020). 75% of market peaks generally occur +2 years after peak earnings and record earnings are fuel for corporate buybacks.

The odds are in your favor as it relates to staying invested in the equity market right now. No one is forcasting a recession at a level above the 10% probability mark and our MONCON model is at a 5—the lowest probability reading for a recession. The economy is in expansion and according to a recent Goldman Sachs report, there is an 87% chance that investors will enjoy a positive return over the next year with a 64% chance of a +10% return and 30% chance of a +20% return.

No guarantees, but we play the odds. And these are great odds. Here are some charts from Goldman.

Odds of Returns During Expansion

This next chart highlights that past economic expansions are generally related to noteworthy market upside, even after gains like we have experienced since the 2020 trough–so there is a lot of precedence for more market returns.

EquityTroughReturn

Finally – I’ve written about this before, but market pullbacks are inevitable. I mention it again because, well, it’s true, BUT ALSO, there was a chart in that same Goldman report that highlights what I’ve mentioned on this before: shit happens. At a 95% probability level, it’s essentially statistically impossible to avoid a 5% pullback, and there is a 75% chance of a 10% pullback over an investing year when valuations are high (that’s the 9th and 10th decile mentioned).

Probability of a Drawdown

So again, because we like to deal in probabilities (odds), it’s essentially assured that you will participate in a 5% pullback, and HIGHLY PROBABLE, you will experience a 10% pullback.

Pullbacks happen during market highs, but they are generally short-lived, so my opinion is that they are not good reasons to exit portfolios and hedge. ESPECIALLY NOW! Here’s some evidence again from the same Goldman report.

HistoricalSeasonalityInvesting

As always, our best advice is to hedge against losses by having a cash position that enables you to ride out any short-lived pullback.

Keep looking forward.

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David B. Armstrong, CFA

President & Co-Founder

Dave got into the industry when he discovered his passion for finance in his mid-20’s. He’s a combat veteran and served as an officer in the United States Marines Corps on both active duty and in the reserves, retiring at the rank of Lieutenant Colonel. While serving on active duty, Dave was unable to spend money on deployments, so he became a self-taught investor. Along with a few bucks cash as a bouncer, his investing performance grew to be good....

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