Note on October Market Declines

Since our Q3 newsletter, the markets have noticeably declined. Though the S&P 500 index rebounded in the final two days, October was the largest calendar-month drop for the index in more than seven years.

Downturns make good stories. The media taps into investor anxiety. Casual investors start paying attention.  

We want to take a moment to offer our thoughts and what steps we are taking.

Market Narratives

At its low on October 29, the S&P 500 had dropped about a tenth of its value – or $2.5 trillion – in four weeks.

Many stories have been proposed for the decline – from trade wars, to election jitters, to broader concerns about the economy. Each may contain some truth. However, each belies the reality that we never really know what causes the markets to move.

Humans use stories to make sense of a chaotic and unpredictable world. Doing so with short-term market volatility offers an illusion of control – if a downturn’s cause is knowable then the solution may be too.

In reality, the market is a mutating organism that responds to an ever-changing environment. Investor sentiment (i.e. fickle human psychology) is the primary driver of day-to-day stock prices. With this in mind, we counsel against applying straightforward explanations to the market.

The Market Is Terrible at Predicting Recessions

Moreover, there is little reason to believe that the market has special insight into where the economy is headed. Courtesy of investment writer Ben Carlson, here’s a table showing the S&P 500’s returns before every recession since the late-1920s:

recessionhistory.png

The media often asks whether a market decline indicates a recession is on the horizon. There is little historical evidence that the market is forward-thinking in that way. With the exception of the months before the 2001 recession, there are no clear examples of the market predicting a recession.

We will have a recession at some point, but the market is unlikely to let us know ahead of time.

What We’re Doing

October’s events do not offer a compelling reason to change our outlook. Still, we see the downturn as an opportunity to be constructive.

We want to control what we can control. Stock market declines provide opportunities to deploy tactics that – no matter the market environment – add value.

One tactic is rebalancing. We manage our clients’ portfolios to target asset allocations, e.g. 50% stock and 50% bond. If a market decline meaningfully changes that balance, then it may prompt us to rebalance to the target allocation (see example below). In essence, we’re looking to take advantage of one of the most powerful positive forces in investing: buying low.

rebalancing.png

A second tactic is tax loss harvesting. In a taxable account, if an investment’s value is lower than its cost basis, then we can sell the investment, realize a capital loss for tax purposes, and buy a similar investment with the sale proceeds. You end up with a similar investment profile. Plus, you also have a current tax year capital loss to offset capital gains.

Volatility reminds us of how stressful investing can be. Please let us know if you have any questions or would like to review your investment goals.