Ponderings in a Slow Market

One of the benefits of a 20+ year career in this industry is that certain things become predictable over time.  As we slowly transition into the later phases of the economic cycle, several things are beginning to happen that, fortunately, I have seen before, and now are no longer a surprise to me.  

Sideways volatile markets


This type of market behavior appears when investors begin to believe that the market may have gotten "ahead of itself."  In other words, as company earnings go from beating analysts' estimates quarter after quarter to maybe hitting or slightly missing goals, some of the excitement and momentum of a bull market begins to drain off.  Last quarter, the economy actually contracted a smidge; this quarter the economic news appears to be a bit better, and the majority of the economic indicators that we pay attention to are looking just fine - but there is still a sense of slowing momentum in the capital markets.  

 

This can be a dangerous time for investors.  It is during this time investors look at their accounts and say to themselves, "Why isn't my account growing?  I'm only up 2% or 3% for the last 6 months or so..." and begin to make unnecessary changes to a perfectly good investment policy, only to pay a hefty price for it later.  This time in the economic cycle (mid-to late phase) is characterized by periods of sideways, boring market movement (or lack thereof) interrupted by sudden POPS of growth (or downward market corrections that typically are brief).  Timing those "pops" is very difficult, so patience is necessary to ensure that you remain disciplined and true to your investment strategy when the market seems to be doing a whole bunch of nothing.

 

It can be helpful to know that during the last 2 economic cycles - the later years of the economic cycle experienced good returns in the stock market, even as interest rates rose and markets were somewhat bumpy.  For example, the average annual return from the S&P500 index from 1996 to the beginning of 2000 was a whopping 26.4% before the economic cycle ended and the country transitioned into recession in early 2000.  Nearly eight years later, as the economic cycle wound down and we approached the Great Recession, we again saw positive stock market returns, with an average return from the S&P500 of 9.2% from the beginning of 2004 until the end of 2007, when the recession officially began. (1)


My point is simply this - rising interest rates and a slowing (but not recessionary) economy do not necessarily mean that we cannot get respectable returns from our investments.  What it DOES mean, however - is that it requires more patience, more discipline, and that investors must endure varying periods of boredom and volatility as they seek those returns.

Not much return from bonds


Currently we are seeing a slow decline in bond prices across the board.  This is good if you are buying into bonds, because their prices are cheaper than at any time in the past 12 months - but bad if you already own them because you are seeing them drop in your accounts.  The real question is - what is our fixed income outlook going forward?


If we look at the returns data from the past two economic cycles - we find that, during the latter phases of the previous two economic cycles, as interest rates BEGAN to change (in 1996 and in 2005), the Barclay's Aggregate Bond Index returned only about half of the return from the previous years. HOWEVER, we also find that this anomaly only lasted about a year or so -  and after the bond market had adjusted for the changing environment, bond returns returned to their normal averages of 4-6% through the end of the cycle until the next recession began in 2000 and 2007. (2)  So - in short - a "hiccup" and then business as usual for bond investors.


 

Much has been written about a "Bond Bear Market" coming as soon as the Fed starts to raise interest rates, and many TV pundits are getting their 15 minutes of fame by emphasizing how investors should avoid bonds (but offer no reasonable alternative for safely investing their money).  I believe that the Fed will be very careful with interest rate increases when they begin, that the price adjustments within the bond markets have already begun, and that we will continue to see some volatility within the bond markets.  HOWEVER, historical bond market behavior also suggests that investors will still reap better returns from properly designed bond portfolios than by putting the money in the bank - and that bond portions of the portfolio still give us some protection against those unexpected stock market corrections that tend to occur from time to time.  So again - patience through this period of market adjustments should reward investors reasonably soon.


Final Words 


My final thoughts on overall portfolios is optimistic.  The latest economic data we are seeing is an improvement over last quarter's.  Greece and the likelihood of its ejection from the European Union is again center stage.  I believe this is overdone - there is a lot of drama surrounding the entitlement-minded Greeks who, by all meaningful measures, have already defaulted on their debts, have no intention of rolling up their sleeves and making necessary austerity changes to get their country's finances in order, and mostly are protesting the fact that the hard-working Germans don't want to give them billions more Euros with no measurable changes in Greek society.  This is creating some volatility in the international markets, but it is mostly about day-trading the issue and not a systemic failure.  Greece's total economy is about twice the size of Louisiana's economy - and not enough to completely unravel Europe's recovery from their double-dip recessions they recently endured.  I believe we have reasonable return opportunities for several more years until the next recession appears - but it will require investors have patience, as those returns are likely to "pop" unexpectedly here and there.  Should the data change, or the odds of a recession measurably increase - we will be quick to keep you in the know!

 


(1, 2)  Dimensional Funds Matrix Book 2015

Paragon Wealth Strategies
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