When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors stay disciplined during purported “crises.”
At the end of June this year, UK citizens voted in a referendum for the nation to withdraw from the European Union. The result, which defied the expectations of many, led to market volatility as participants weighed possible consequences.
Journalists responded by using the results to craft dramatic headlines and stories. The Washington Post said the vote had “escalated the risk of global recession, plunged financial markets into free fall, and tested the strength of safeguards since the last downturn seven years ago.”1
The Financial Times said “Brexit” had the makings of a global crisis. “[This] represents a wider threat to the global economy and the broader international political system,” the paper said. “The consequences will be felt across the world.”2
It is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain’s prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.
But within a few weeks of the UK vote, Britain’s top share index, the FTSE 100, hit 11-month highs. By mid-July, the US S&P 500 and Dow Jones Industrial Average had risen to record highs. Shares in Europe and Asia also strengthened after dipping initially following the vote.
Yes, the Brexit vote did lead to initial volatility in markets, but this has not been exceptional or out of the ordinary. One widely viewed barometer is the Chicago Board Options Exchange Volatility Index (VIX). Using S&P 500 stock index options, this index measures market expectations of near-term volatility.
You can see by the chart above that while there was a slight rise in volatility around the Brexit result, it was insignificant relative to other major events of recent years, including the collapse of Lehman Brothers, the eurozone crisis of 2011, and the severe volatility in the Chinese domestic equity market in 2015.
None of this is intended to downplay the political and economic difficulties of Britain leaving the European Union, but it does illustrate the dangers of trying to second-guess markets and base an investment strategy on speculation.
Now the focus of speculation has turned to how markets might respond to the US presidential election. CNBC recently reported that surveys from Wall Street investment firms showed “growing concern” over how the race might play out.3
Given the examples above, would you be willing to make investment decisions based on this sort of speculation, particularly when it comes from the same people who pronounced on Brexit? And remember, not only must you correctly forecast the outcome of the vote, you have to correctly guess how the market will react.
What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on your long-term investment goals.
The danger of investing based on recent events is that the situation can change by the time you act. A “crisis” can morph into something far less dramatic, and you end up responding to news that is already in the price.
Journalism is often described as writing history on the run. Don’t get caught investing the same way.
1. “Brexit Raises Risk of Global Recession as Financial Markets Plunge,” Washington Post, June 24, 2016.
2. “Brexit and the Making of a Global Crisis,” Financial Times, June 25, 2016.
3. “Investors are Finally Getting Nervous about the Election,” CNBC, July 13, 2016.
OUTSIDE THE FLAGS
By Jim Parker
DFA Australia Limited
WE SHOULD EXPECT VOLATILITY
Do returns during January provide information about returns during the remainder of the year?
As we would expect over any period, prices in January 2016 changed from day-to-day as aggregate expectations changed and investors processed new information. During the month, the S&P 500 Index had a return of −4.96%, the ninth lowest return for the index since 1926. The first two weeks of January was the worst start to the year for the S&P 500 in history, with the index returning −7.93% from January 4–15.
The market events of January 2016 provide an opportunity to examine several questions important to investors and revisit some fundamental principles of investing in capital markets.
Based on this information, some investors may wonder whether the returns in January have some predictive power for the returns during the remainder of the year. Exhibit 1 shows the returns of the S&P 500 Index for the month of January compared with the subsequent 11-month return (i.e., February through December). We find that a negative January was followed by a subsequent 11-month return that was positive 59% of the time, with an average return of 7%, indicating a negative January does not predict poor market returns for the rest of the year.
One additional not: if we look at the five lowest January returns, excluding January 2016, the average return for the remainder of the year was 13.8% and none of these years finished in the lowest 20 years of annual returns for the S&P 500 Index.
PREVIOUS MARKET DECLINES
What have we seen during previous market declines?
As mentioned above, the YTD return for the S&P 500 through January 2016 was −4.96%. From the previous high on November 3, 2015 through its low on January 15, 2016, the S&P was down −10.43%, its second decline of at least 10% since the beginning of August 2015. We can look at the data in Exhibit 2 to see how the US market has performed in subsequent periods following different magnitudes of decline. The exhibit looks at previous times when the S&P Index has declined by 10% and 20%, and shows the subsequent one-, three-, and five-year return. Independent of the magnitude of decline, on average, the return of the S&P 500 over the periods referenced has been positive and greater than the long-term average of 10.02% in half of the time periods observed. The chart also provides information on developed ex US and emerging markets, where we have seen similar results.
Is the recent period abnormally volatile?
For the period January 1926 to the December 2015, the S&P 500 had a compound return of 10.02% and a standard deviation of 18.85. Looking over a more recent period, from January 2010 through December 2015, the return for the S&P 500 has been 12.98% with a standard deviation of 13.09. Comparing these results with other historical periods, we can see the recent period has not necessarily been more volatile. During the so-called “Lost Decade” from January 2000 to December 2009, the S&P 500 Index had a compound return of −0.95% and an annualized standard deviation of 16.13. When we continue to look at the data in Exhibit 3, grouped by decade starting in January 1930, we see periods of higher and lower returns as well as periods of greater and lesser volatility.
IMPORTANCE OF DISCIPLINE
While in the midst of a market downturn, we may be inclined to look for some type of signal as to what the recent period means for future returns or to assume the current period is somehow different from what we have observed historically. Before jumping to conclusions or attempting to make predictions about what the future may hold, analyzing the available data can provide perspective. It is also important to remember that there is ample evidence that suggests prices adjust in such a way that every day there is a positive expected return on our invested capital. While the realized return over any period may be positive or negative, in expectation we believe markets will go up. As investors, we should remain disciplined through all periods in order to capture the expected returns the market offers.
All Charts by Dimensional Funds