Rattled by the markets? Consider spreading your bets

Rattled by markets If you or your clients are feeling rattled by the markets so far this year – consider yourself normal. When the markets get messy like this, generally it’s because investors have lost confidence in their ability to clearly see the future. In this particular instance, that is catalyzed by
  • General distrust of the durability of economic growth in China
  • Confusion about how to interpret the dramatic drop in oil prices (down 25% year to date as of January 20, 2016)1
    • Optimists see in it a discount at the pump and therefore a buoyed consumer;
    • Pessimists see in it slumping revenues from the energy sector and higher junk bond defaults from wildcatters washing out
    • Can they both be right?
  • Concern about the sustainability of the record corporate profits being posted
Typically what investors can expect during these sorts of environments of uncertainty is overreaction. But, what can you do to help ensure your clients don’t get caught up in the sentiment trades?
  1. Provide clients with context about historical market cycles/corrections
    1. They are normal. Market corrections can even be considered helpful (for clearing out mispricings, euphoria, etc.), but you need to view them in their totality, not one at a time;
    2. They are frequent. The type of correction we experienced in the week of January 19 (i.e. corrections of at least 10% over a 15-day rolling period) has happened 15 times since 1995.2 So, you could argue that investors should be accustomed to such market gyrations and should be able to keep their cool. Of course hindsight is 20/20 and investors attempting to keep their wits about them are fighting a lonesome battle given the way market drops are typically presented, full of alarm bells, in the media today.
    3. They are both idiosyncratic & unforecastable. What happened in one cycle doesn’t tell you much about what might happen in the next cycle.
    4. Remind clients we are also in an election cycle. Attacks, hyperbole, distortion and gloom are stock in trade in typical election cycles.
  1. Guide clients to better balanced portfolios, which tend to support more even-tempered investors. Knowing that market cycles are both ups and downs, frequent and unpredictable – what should investors do?
Invest across cycles – i.e., diversify. Investing for any one market environment successfully requires a crystal ball. If you haven’t got one, consider spreading your bets. In this vein, I would argue that the diversified client is the smart client: it’s the client who knows that winning is a balance of getting it right and not get getting it all wrong over a long period of time. That’s what we attempt to do on our clients’ behalf here at Russell. Of course, diversification can’t protect against loss. In the words of our strategist team: “there are markets for taking risks and markets for managing them. We are likely in the second kind.” In building your case with clients, bring to their attention the fact that diversifiers have contributed recently while global equity markets3 have been down double digits. Specifically,
  • Real assets have acted as powerful diversifiers
      • Real assets is more than simply commodities/oil. Real estate, infrastructure, commodities have out-performed global equities in the downturn year to date as of January 20, 2016. They're down around 6% compared to the double digits of the global equity markets.4
    • Commodities is more than simply oil. Oil is grabbing headlines – but industrial metals, precious metals, agriculture are holding up better. Gold (precious metal) is up 4.5% year to date as of January 20, 2016.5
  • Diversifying across the market cap spectrum has historically helped.
    • In periods of risk aversion, small cap equities tend to lead the market down – that has occurred again this time.6 The small cap Russell 2000® Index was down -13.0% year to date as of January 20, 2016, whereas the large cap Russell 1000® Index was down -10.1%.
  • Currency diversification has been important, too.
    • There has been big divergence in currency performance over the past 12-24 months. The USD has obviously been strong. Canadian and Australian Dollars have been much weaker, due to their ties to energy, industrial metals and iron ore complexes. In contrast, the Japanese yen and Euro are holding up better.
  • Bonds have not failed investors.
      • Bonds are the balance and ballast when things "go wrong" in the equity market. Bonds have proven their weight in portfolios – up about 1% year to date as of January 20, 2016.7

The bottom line

This is why sophisticated forms of diversification can be desirable – not to maximize return in any one cycle, but to maximize the opportunity for success across many cycles. The only way investors could avoid
 
this cyclicality is very, very unappealing – they would have to accept very short life spans! The typical American investor is going to live through nine or 10 cycles. Furthermore, advisors typically guide clients through an average of nearly six cycles (5.8 to be exact). So neither advisors nor their clients should try to bet the ranch on any one market cycle. Including this one!

1 Oil prices represented by WTI (West Texas Intermediate) crude. Source: FactSet.

2 Based on Russell 1000® Index as at 1/20/16.

3 Global equity markets represented by MSCI EAFE Index, which was down 11.5% YTD as of 1/21/16.

4 Based on performance as of 1/20/16 for FTSE EPRA/NAREIT Developed Index Net, S&P 500® Global Infrastructure Net Index, Bloomberg Commodity Index Total Return, versus MSCI EAFE Index.

5 Based on February 2016 Gold Futures contract year-to-date as of 1/20/16.

6 Represented by performance of Russell 1000® Index and Russell 2000® Index year-to-date as of 1/20/16.

7 Based on the Bloomberg U.S. Aggregate Bond Index as of 1/20/16