Half Empty or Half Full?

half full and empty

Topic: Investments

John C.A. Stevenson CFA

December 4, 2018

Image used with permission: iStock/wakila


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Half Empty or Half Full?

According to the Chinese zodiac, 2018 is the Year of the Dog. For investors, 2018 has been more like the year of the roller coaster.

In early January, stock markets around the world continued the exuberant climb that characterized 2017. Investors were optimistic and confidence was high. Volatility in the U.S. stock market, as measured by the VIX, hit an all-time low on January 5. Investing was easy!

Over the months that followed, however, anxiety increased. Interest rates in both Canada and the U.S. steadily rose during the year, and investors were spooked on several occasions that the increase might be sharper than expected. Trade worries – whether they be the U.S. steel and aluminum tariffs, the NAFTA renegotiation, or the escalating tension between China and the U.S. – caused much hand-wringing. Currency crises in both Turkey and Argentina led to concern of more widespread declines in emerging markets. Geopolitical concern about Iran and North Korea also percolated in the background.

By the time October arrived, the weight of investor concerns was overwhelming, particularly when one considered that the longest bull market in U.S. history must surely be in its late stages(1). Confidence and sentiment turned universally negative. In Canada, the TSX declined 6.3% in October. Elsewhere was equally grim. In the U.S., the S&P 500 fell 5.4%, while EAFE dropped 6.6%, and Emerging Markets plunged 7.3%(2). Typically, bonds would have softened the blow, but they fell as well. It was a point in the year where it truly felt like there was nowhere to hide. Through mid-November, 90% of the 70 global asset classes tracked by Deutsche Bank had negative year-to-date returns(3). This outcome is the worst in a century of data. The previous record was in 1920, when 84% of the asset classes tracked had negative returns. This is a stark contrast to 2017, when just a single asset class – the bond market in the Philippines – had a negative return.

Investor emotions and psyches were challenged by two phenomena by mid-November. First, it had been a long time since we’d had a serious market pull-back. Many forgot what it was like! On average, the S&P 500 Index drops by 10% once each year and by 5% five times each year(4). Not only was the 2016/2017 period notable for great returns and low volatility, in the 18 months ended December 31, 2017, there were no 5% drops in the U.S. There should have been seven or eight during that period. The chart below shows how “normal” it is to have significant intra-year declines despite the upward trend of markets – this time using TSX Composite data.

Market Declines and Returns

The second phenomena relates to what psychologists call the “recency bias”. Humans tend to remember recent events most vividly and extrapolate them into the future. That led many investors to conclude that markets would continue to plunge. It was easy to focus on the recent spate of bad news and forget about some of the good news – that the Canadian and the U.S. economies remain strong, inflation is under control, and corporate profits continue to expand. Moreover, growing earnings and the decline in stock prices have resulted in more attractive valuations.

This sentiment seemed to hit bottom right around U.S. Thanksgiving. Immediately after, stock markets turned sharply higher. In the last week of November, the S&P 500 staged its strongest weekly rally in seven years. It gained 4.8%, while the Dow Jones rose 5.2% and the NASDAQ jumped 5.6%(5). Importantly, notwithstanding the pullback in October, many investors have had a decent 2018 so far. Returns in the principal Nexus funds are modest, but positive, through the first 11 months.

With the roller coaster ride of 2018, it is reasonable that many feel uncertain. Is the market outlook like a glass that is half full or half empty? The answer is easy if you have the right time horizon. Over the long term, economic growth and investments in wisely chosen companies will generate good returns for patient investors. In the short term, anything can happen, as has been illustrated by the events of 2018. Almost a century ago, Bernard Baruch outlined what happens to those who think they can predict the market’s short-term movements: “The main purpose of the stock market is to make fools of as many men as possible.”

The bottom line is that the gyrations of 2018 are a lot more normal than the placid conditions of the last few years. What is key is to focus on the long term, and that is most easily done when investors have clear objectives and a clear financial plan. The past 11 months have underscored the accuracy of Warren Buffett’s admonition that “investing is simple, but not easy.”

(1)  The debate over whether the current bull market is the longest or second longest relates to whether one uses closing market levels or intra-day levels to declare the 1990 decline a bear market.
(2)  All returns quoted in this blog are total returns in Canadian dollars, unless otherwise specified.
(3)  The Wall Street Journal, November 25, 2018. Returns stated in U.S. dollars. The 70 asset classes cover the full spectrum of the global investment landscape, from stocks and bonds to commodities and real estate.
(4)  JPMorgan, “Guide to the Markets”.
(5)  Price only returns in U.S. dollars.

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