Wake me up when September ends.
Summer is officially over, and in some parts of the country, the weather is getting a little gloomier. Meanwhile in financial markets, it seems like some investment pundits’ forecasts are also a bit gloomier. Maybe the change in weather is impacting more than just the temperatures?
A couple of the many foreboding predictions I have come across recently include “Stanley Druckenmiller says the stock market is in an ‘absolute raging mania’”1 and “Bond king Jeffrey Gundlach says the surge in retail investor activity is ‘downright terrifying.’”2
It’s true stock markets have offered investors a bumpy ride so far in September. We saw a steep pullback in technology stocks, with the technology-heavy NASDAQ 1003 down ~8% in the first few weeks of the month. Tesla declined 21%4 on Tuesday, September 8 after it was snubbed from inclusion in the S&P 500. Our view on technology stocks was summed up well in Investment Committee member Janice Deringer’s letter last month.
If we had to make a list, there appear to be a number of reasons to be concerned about the future of the stock market:
- Election uncertainty
- COVID-19 second wave
- Not enough stimulus
- Too much debt/deficit
- Low yield environment
- Disconnect between the market and the economy
Depending on who you speak with, there are probably many more reasons that can be added. So how do we at Wipfli Financial Advisors protect our clients against the risk that each of these challenges present?
First and foremost, it’s by recognizing that many of the things we are worrying about today may already be priced into the value of stocks. So-called pundits are often forced to eat humble pie. We only need to look as far back as March of this year to remind ourselves of this. When the COVID-19 pandemic hit and lockdowns were imposed across the country, the magnitude and duration of the economic upheaval was unknown. But as many thousands of buyers and sellers transacted with the disparate information at their disposal, the stock market priced in various scenarios of what could happen.
Although the U.S. market was down over 30% by March 2020,5 it then began to rebound swiftly when some of the worst scenarios seemed less likely to play out. By mid-May the S&P 500 had climbed back up to being down just 10%6 for the year, and it was around that time that Mr. Druckenmiller (not to pick on him) claimed “the stock market’s risk-reward is the worst he’s ever seen.”7 Less than a month later, he admitted to being humbled8 by the market, which continued to rise through this past August.
The takeaway is to be wary of forecasts (even from billionaires) and to avoid making any investment decisions based on them.
So that tells you what not to pay attention to, but risks (some known and others unknown) are still out there. How should you be defending your portfolio against them?
To manage risk within portfolios, Wipfli Financial Advisors deploys two time-tested defenses.
Defense 1: Bonds
They can be boring, and their expected returns are lower than stocks, but bonds offer much-needed stability to help withstand periods of stock market distress. We are often asked about different exotic hedging strategies to mitigate risk. But we remain confident that the best solution to mitigate stock market risk is an appropriate allocation to core bonds.
After the 2008 great financial crisis, we witnessed an increase in expensive liquid alternative funds that were marketed to provide a hedge against a 2008-like market event. Fast forward 10+ years, and the evidence shows that most investors would have fared better with a high-quality, well-diversified bond allocation.
Another concern often voiced is, given the low yield environment, do bonds still make sense? And our answer is that they absolutely do. In the aftermath of the great financial crisis, from 2009-2015 the Federal Reserve held the federal funds rate near zero. Over that same time period, the Barclays U.S. Aggregate Index (an index of investment grade U.S. taxable bonds) returned 4.1%9 per year. Inflation over that same time period was 1.7% per year.10 Thus, the return of investment-grade bonds beat inflation even through that past period of low yields.
Defense 2: Diversification
Often called the only free lunch in investing, diversification provides a significant benefit as a risk mitigation strategy. For those who worry about the lofty valuations of the largest names within the indexes (remember the strong market rebound has been led by a relatively small number of stocks, and there are many more within the overall market that are still negative for the year), diversification means holding a U.S. stock portfolio that contains more than just the largest, growthiest names in the market that have performed well recently, but may not be the stars of tomorrow. It also means having exposure to international stocks that have lagged U.S. stocks in the past few years but may behave differently coming out of the pandemic.
Navigating future uncertainty
Neither of these two defenses can eliminate the possibility of loss; there is always some amount of risk that you must be willing to accept as an investor in order to earn a higher return.
With that said, you can expect many predictions and forecasts over the next few months that will be worded to make you believe you need to take some action. You can probably also expect to see some heightened market volatility as we get closer to November. Just remember, instead of making a knee-jerk reaction, there are more prudent risk mitigation strategies to navigate uncertainty.
If you’d like help introducing more diversification into your portfolio, contact one of our advisors:
Or continue reading on:
- The temptation of bright, shiny things …
- Answering our clients’ most common questions about the pandemic, stock market, negative news and more
- Ignore Wall Street predictions and embrace the uncertainty