(Mar 13): Firstly, there is no sugar-coating over what has transpired. It is a painful fall in equity markets for all of us who are invested in markets. Even in a historical context, this one is big. The S&P 500 index is down 18.9% and almost breached the 20% fall from peak to bear market territory overnight.
It is easy to forget, but we were here before. Just over a year ago towards the end of 2018. Just like then, many indices around the world have fallen by more than 20% and entered bear market territories. Of course, it is the speed at which this fall has occurred that has been surprising but markets falling 20% happens more often than we think.
There have been 11 times the S&P 500 index fell by more than 20% and it does not include 2018 or this year. However, the following table also puts into context how severe the correction has already been in any ranking of past historical precedents. It is already the 7th largest daily fall (See Table 1) and if markets did nothing more from here until the rest of the year, it would be ranked 5th in highest annual falls.
Secondly, even if it feels like it is, the market rarely falls in a straight line and we will see rebounds but we cannot time the bottom. While this correction does not yet enter into the top 5 of the rankings for weekly or monthly falls. We can see that this is a continuation of the fall from February which is in the top 5 for weekly. If we combine the end of February into March, then the monthly fall would also be top 5.
However, it is interesting to note that there is not a direct correlation between short term corrections in weeks and months and annual falls (See Chart 2). The annual number, except in extreme cases, is rarely as bad as the worst monthly falls, which suggests that we will see rebounds. Rebounds may end up being a precursor to further falls, but markets will never fall in a straight line even when it feels like it is.
Thirdly, diversification through bonds is definitely working as it should. While equities have fallen, bonds have been rallying strongly. The Endowus 100% bond portfolio is up almost 3% year to date. As we have been stipulating for a while, in a situation of falling equities due to fundamental factors, bonds have been and remain a good diversifier and have protected some downside.
Unfortunately, like with any winners, we never have enough. It was the reverse case when equities were rising relentlessly and bonds were a drag to returns. Historically in recessions, our studies show that bonds provide positive returns despite market falls and show why diversification remains important in any portfolio.
Fourthly, it is easy to forget during sharp market corrections, but any large or sharp fall in markets resets the market to levels from which we see a sustained recovery as it is positively skewed to the upside over the long term — even if there is a recession. Some of the largest single-day returns have come after the biggest falls. Some of the most protracted and sustainable bull markets have been born out of large market falls.
The problem is that it is difficult to time the bottom of markets and it is why it is easier to remain in the market and have a more diversified portfolio rather than try to time the market. You should allocate to the risk (equities exposure that drives long term returns) level that is appropriate to your own risk appetite. Chart 3 shows what markets do before, during, and after a typical recession.
There is a maximum peak to trough drawdown at some point during the recession. However, we do not know whether it is before, during or after the recession. It is impossible to time. But what we know is what happens afterwards. It is also impossible to time that bottom to capture all of the upsides when it comes. In fact, it’s ironic in the midst of all this chaos, but if you actually slept right through all the recessions then you can ignore that fall (MDD) and you would have been just fine enjoying the rally afterwards.
Finally, markets are forward-looking and price in the future faster than you think. We cannot predict the forward trajectory of markets (and this may sound counter-intuitive) but it is true regardless of where the economy is actually headed. Let me explain. If the Covid-19 outbreak worsens especially in the developed markets in the US and Europe, the economic dislocations will be persistent and large.
However, due to the nature of the downturn being a result of an external shock, we are likely to see a V-shape in the trajectory. We know the shape. But we just do not yet know the depth and extent of the downward stroke of the V. The current market volatility is reflecting that uncertainty and markets are reacting to each incremental news flow that comes out. It is this change at the margin — the marginal delta change in expectations — and not the absolute that moves markets.
Therefore, markets may have already priced in a worst-case outcome or could fall further to price in a major recession and a global epidemic. Whichever becomes the future scenario, it is likely that even if we later confirm this through large earnings declines from listed companies driven by a major slowdown in demand, there is a likelihood that markets will reflect all of this and bottom before the economic data even confirm the reality of a recession, as so often is the case.
Furthermore, the markets may look through bad data to a recovery and possibly policy responses that may boost demand and monetary conditions long term. We may not be there yet, but it is how markets operate as a forward-looking indicator. As investors, it is something important to always keep in mind. Not to invest backward but forward.
So the question is what do we do? I think it is an important time to reassess whether your risk appetite is appropriately selected and assess your exposure to markets. It is still relevant to ask yourself whether we should take a little off the table.
But equally important is asking whether we are not exposed enough to markets for the long term and should be adding to markets on the way down. I remember a friend who unluckily started investing in 2007. Luckily, he kept investing through the downturn every month from his wages and he is a happy man now.
I am certain he will do so again. Each individual’s personal circumstances are different but for those with income and a long(-ish) time trajectory to retirement, you should be adding on the way down. However, what we should not be doing is trying to time the market. I want to highlight some of the things that I shared with you previously during your onboarding process to help you frame it in the right way.
Investing is a discipline. With markets entering a new period of volatility with sharp movements and corrections, it is easy to be swayed by emotions. The onset of an array of external shocks, such as epidemics, trade or oil production wars, changes in monetary and fiscal policies by governments, a higher degree of uncertainty is inevitable. Uncertainty and fear are two reasons why it is common to be tempted into the wrong action by chasing markets or to inaction. But time and time again the markets show us that we should remain invested in markets at levels of risk we are comfortable with rather than stay out and try to time our entry into markets.
We should be humble. It is tempting to try to time the market. We love being able to tell our friends that we bought the bottom and sold at the top, though evidence and experiences have shown us how difficult this is to do consistently. We do not need to be heroes. We need to harness the power of markets, which over the long term gives steady returns, and rely on the powerful effects of compounding. We can do this successfully by exposing ourselves to compensated risk in order to achieve the long-term returns of the markets.
Investing is a process. One way to mitigate market timing risk is to stick to regular savings and investment plans that can get us to our goals. Utilising the institutional framework of risk-based asset allocation, we must follow a disciplined process and take advantage of the optimization and rebalancing of the portfolios that Endowus provides. The recent market moves only prove once again that trying to time the market is a futile effort for even the best of us.
Investing is about your future. Our mission is to help you secure a better financial future. A rise in market volatility should not deter you from taking important steps in securing that successful future. At Endowus, we are focused on improving the three areas that all of us need in order to have a better investment experience:
(1) good personalised advice,
(2) access to better products that are both sophisticated yet suitable, and
(3) sharply lower costs to improve your chances of investment success.
We believe our systematic approach to your financial journey can lead to a better future and greater security for you and your loved ones. While some of this content may be repetitive, I hope there are some new insights you can take away from it.
Samuel Rhee is founding partner, chairman and chief investment officer of Endowus, a FinTech investment platform. He was previously the CEO and CIO of Morgan Stanley Investment Management in Asia
