When Stocks Decline, Alternative Investments May Help (Part 1)
Editor’s Note: To learn more about other options for the accredited investor, we suggest this webinar.
First of two parts
Stock prices have been rising for more than six years. Are you prepared if they start to fall?
No one knows, of course, when that will happen – but historically it always has. Maybe stock prices will continue rising short term, but being prepared for a potential drop by diversifying your portfolio could help prevent major losses.
Historically, a drop in stock prices is overdue. The 16 bull markets since 1926 have lasted an average of 3.8 years, so the current bull market is already well above average in duration. It has lasted about as long as the bull market of 1974 to 1980, which stretched to 6.2 years. Only two post-World War II bull markets have lasted longer – the bull market for the period 1990 to 2000 lasted 9.4 years, while the bull market of 1949 to 1956 lasted 7.2 years, according to Forbes.
Since 1926, the stock market has been through 19 bear markets, with one on average nearly every five years, according to Kiplinger. A bear market is one in which market indices such as the S&P 500 and Dow Jones Industrial Average decline at least 20% over at least two months.
In between, there are typically plenty of market “corrections.” During the first four-and-a-half years of the current bull market, there were 11 corrections, in which the market declined more than 5%.
Historically, the frequency of corrections increases as a bull market ages, so recent market volatility could continue.
QE’s Impact on Markets
If history repeats itself, the current bull market will end soon. However, this bull market is unlike any other, in that it has been largely pushed along by monetary policy. (See CNBC’s report on expectations for today’s Fed meeting.)
Based on his discussions with financial advisors and asset managers, the Federal Reserve Board’s quantitative easing (QE) program is widely credited with boosting stock prices over the previous six years, according to Jeff Kelley, chief operating officer and senior vice president at Equity Institutional, a passive custodian for alternative assets.
QE ended in October. In response to the financial crisis, the Fed began buying bonds, including mortgage-backed securities, in 2008, in an effort to stimulate the housing market and the economy as a whole. Over three rounds of QE, the Fed’s balance sheet increased from under $1 trillion to $4.48 trillion.
When the Fed took trillions in government bonds and mortgage-backed securities off the market, the investors who would have bought them invested elsewhere – often in corporate bonds. As demand for corporate bonds increased, so did prices. When bond prices rise, interest rates fall, which improves the ability of companies to borrow.
Falling interest rates also caused investors to move money into riskier assets for higher returns, which caused the stock market to soar.
The money created by the Fed to buy the bonds also increased the money supply, weakening the dollar. A weaker dollar helps stimulate exports by reducing the price of American goods in other countries, and may also help prevent deflation.
QE also boosted investor confidence and, in doing so, boosted not only stock prices, but the prices of other financial assets. “The central banks’ money-printing has worked not so much by flooding markets with cash, but by restoring confidence in the financial system,” according to the Financial Times. “Investors who feared big losses from another financial shock were reassured by the suggestion that central banks would step in to support asset markets.”
The link between QE and stock prices became such that in recent years, positive economic news often had a negative impact on stock prices and negative economic news often had a positive impact on stock prices. Why? Because investors recognized that the Fed would stop buying bonds when the economy improved.
For example, when then-Federal Reserve Chairman Ben Bernanke signaled in May 2013, that the Fed might soon begin cutting back on its bond purchases because of an improving economy, a “taper tantrum” resulted – stock prices dropped and interest rates increased.
The Fed has since worded its statements with great caution. It managed to gradually reduce and then end bond purchases by shifting investors’ focus to interest rates and promising that they would remain low for a “considerable time,” even after the end of QE.
Meanwhile, with recession having spread worldwide, other countries have followed their own “easy money” policies, in some cases including bond buying. In today’s global economy, actions by other countries may have made it easier for the Fed to end QE without spooking investors, as the U.S. stock market has continued to break records, even as volatility has increased.
As a result, though, as The New York Times recently noted, “While a bubble is in the eye of the beholder, it is the case that many assets – almost all the major types of assets on earth, in fact – are at the high end of their historical valuations.”
The Role of Asset Allocation
“To reduce volatility in their clients’ portfolios, the financial advisors I talk to typically encourage them to use asset allocation, in which they diversify by allocating a percentage of their assets to various asset classes and to rebalance regularly,” Kelley, the Equity Institutional COO said.
“In recent years, though, with the stock market outperforming other investments, advisors tell me that many investors have given in to the temptation to invest more in stocks than their asset allocation would dictate. After all, why move money out of stocks when they are performing so well?”
In 2014 alone, the S&P 500 Index closed at a new high 53 times. That averages out to a record-breaking day more than once a week. Stock market performance has been tepid so far this year, but indices have still broken records.
Advisors may also be under pressure from clients, who are bound to ask, “Why am I paying you 1% of my assets every year, when I could get better returns from an index fund that tracks the S&P 500?” “But to achieve long-term financial goals, financial advisors are reminding us that it is important to manage risk, as well as return,” Kelley said. “Having the discipline to stick with a set asset allocation may reduce volatility, helping to cushion the blow when stock prices drop.”
If, for example, stock prices drop 20% and your portfolio drops in value by an average of only 10%, you’ve preserved more capital. You would not only cut your losses in half, but as the market recovers, you would potentially recover more quickly.
Assume two investors each have a portfolio worth $1 million. The value of one portfolio drops 10% to $900,000, while the value of the second, more volatile portfolio drops 20% to $800,000.
Now assume the market recovers and the portfolio that dropped 20% increases in value by 20%, while the less volatile portfolio gains back only 10%. Even though the more volatile portfolio gained back 20%, it is still worth only $960,000, while the portfolio that gained back just 10% is worth $990,000.
This example is included for illustration purposes only. The impact of asset allocation on volatility and returns has been widely debated among the consultant and investment sponsor communities, according to Kelley, but a landmark study showed that diversifying among a variety of asset classes and keeping a steady allocation by rebalancing accounted for 93.6% of the variation in the quarterly returns of the 91 large U.S. pension funds included in the study for the period 1974 to 1983.
A 2000 study that reviewed 10 years of monthly returns for 94 balanced mutual funds and 10 years of quarterly returns for 58 pension funds confirmed that asset allocation accounts for about 90% of portfolio variability from one period to another, and that it accounts for 40% of return variation between funds.
– John C. Drachman serves as team leader, senior writer, and principal of AlphaSegment, a creative group of marketing communications freelancers dedicated to meeting the marketing needs of RIAs, asset managers and financial services providers.