February 2nd, 2017 | by Andrew Tanzer, CFA, "The Global Equation"
Dow Hits 20,000. Now What? (Part Two)
- Recent dips in market indexes have some wondering if the Trump “honeymoon” for stocks is over; some investors are bracing themselves for a possible market correction during Trump’s tenure in office.
- Research on market cycles tells us a correction will occur, but we can’t be sure of the timing, nor should investors try to guess at it.
- Especially during uncertain times, it’s important for investors to keep the longer term in mind; history has plenty examples of styles, sizes, and entire markets cycling out of favor, sometimes for prolonged periods. Yet, we believe that they always cycle back in.
The decline in broad stock indexes in recent days is causing some investors to wonder if the market’s honeymoon with Donald Trump since his election last November is about to be over. Some people are raising the possibility of a bear market during his presidency. For us, the question is not if a market correction will occur, but when it will occur. There’s no political nuance in this statement; it’s simply a reflection of market history and dynamics.
Every presidential cycle—regardless of the political party in power or its respective economic and business policies—has had its share of market drawdowns. Exhibit 1 catalogs the worst stock market swoons of each four-year presidential term stretching back to Herbert Hoover’s. Note that investors experienced sharp market declines even on the watch of pro-business Presidents such as Ronald Reagan.
In the first installment of this blog series, “Dow Hits 20,000. Now What? (Part One),” we noted that we see little to be gained by attempting to predict the future (2016 was a particularly humiliating year for political and financial readers of crystal balls) or to time markets. Instead, we embrace globally diversified, multi-asset class portfolios that we believe will stand the test of time for long-term investors through multiple potential scenarios. I’ll illustrate what I mean with two examples: factor investing and international equities.
Riding Out Factor Cycles
Gregg Fisher, our head of research, discussed investing across multiple market cycles in our recent Winter 2017 Market Perspective client letter. For Gregg, two key influences on long-term investing outcomes are the investor’s holding period and his or her willingness to be different from others for extended time periods. The longer the time horizon, the lower the probability of a poor or negative realized return and the higher the chance of returns in excess of index averages (or “tracking error risk” in financial theory). In the shorter term, markets are prone to momentum (continuation of a trend, either up or down), whereas they display cyclical behavior (reversion to the mean) in the longer term.
A case in point is factor-based investing. Factor premiums are grounded in financial economics and validated (around the world) using market data spanning decades, but successfully harvesting them depends on investors’ ability to stay the course through factor cycles. For instance, historically, average returns for US small company stocks have exceeded those for large cap stocks, and value has outperformed growth. This was the case in 2016, when small cap value, as measured by the Russell 2000 Value Index, outperformed the Russell 1000 Growth Index of large company stocks by a wide 25 percentage points. Yet this outperformance came after a multi-year period that was not kind to the size and value factors. Efforts to time factor premiums can be frustrating since the most rewarding results typically occur in an unpredictable, sudden manner (as in 2016 with size and value), which reinforces the importance of investor discipline (for more detail on growth and value cycles, we invite you to read our research, “Should You Invest in Value, Growth, or Both?”
Still a Case for Global
Similarly, even though 2016 marked the fourth consecutive year in which the S&P 500 Index return beat the MSCI ex-US World Index (+12% vs. +4.5%), we do not think that it is prudent to abandon foreign stocks due to a period of slack performance. Exhibit 2 shows that US and foreign stocks pass through cycles of relative performance, sometimes influenced by currency fluctuation, and sometimes not. A month is not a long period, but we note that from January 1, 2017 to January 30, 2017, the S&P 500 trailed returns in both international developed and emerging market indexes, due in part to the fact that the US Dollar Index, which reached a 14-year high in December 2016, slipped 2.6% in January.
After nearly converging around the time of the 2008 financial crisis, global equity correlations have actually declined in recent years, which enhances the case for portfolio diversification. In sum, regardless of your expectations for the Trump Administration, we continue to believe that, based on both diversification theory and common sense, foreign stocks merit a strategic allocation within a diversified equity portfolio.
In closing, I refer readers back to the Exhibit 1 chart of sharp stock declines during presidential cycles. We make no prediction for the stock market’s performance during the Trump Administration, but we would note that, after every single one of the dramatic corrections reported in Exhibit 1, the markets eventually recovered to post new highs—as we experienced in recent days. So if history is a useful guide (and we think it is), at some point during the Trump presidency we could indeed see a bear market. Most equity investors will hopefully have a time horizon of longer than four years, however, and will be able to ride out any such downturn and recognize it for what it is: part of a time-honored cycle that will, eventually, turn back the other way.