Enjoy the Calm, but Don’t Forget Volatility

Markets have been relatively calm in 2021, despite a steady stream of fearful headlines from financial publications we follow. Now, we don’t think that long quiet period means equities’ smooth stretch is about to be shattered. Volatility can strike or vanish at any time for any or no reason. But we do think getting acquainted with this year’s lack of volatility relative to the norm can help you mentally prepare for whenever markets do hit turbulence.

So far in 2021, the MSCI World Index has had no pullbacks—declines from a prior high—exceeding -5%.^[i] Although there is great variance amongst bull markets (extended periods of generally rising equities), as Exhibit 1 shows, the five bull markets since daily data begin in 1980 (excluding the current one) have averaged around nine declines exceeding -5%. By magnitude, there are typically about seven -5% to -10% pullbacks and a couple of corrections—short, sharp and sentiment-driven -10% to -20% declines. There are always outliers, but as the current bull market wears on, we think it would be unusual not to see more volatility and pullbacks.

Exhibit 1: Frequency of Pullbacks Exceeding -5%

Source: FactSet, as of 2/9/2021. MSCI World price index, 12/8/1982 – 1/9/2021. *Not including the current bull market.

Another way to see this is to slice the data annually. With 56 pullbacks and corrections since 1982, that is about 1.7 per bull-market year on average. Again, having none this year—so far—seems notable, though it says nothing about their likelihood going forward, as past price movements aren’t predictive.^[ii] Still, in our view, there is no time like the present to think through the investment implications of negative volatility returning: how it might knock you off course and what investors seeking long-term growth can do to avoid potentially counterproductive portfolio moves.

Whilst they are generally regular occurrences, substantial pullbacks can draw reams of attention—and commentators’ explanations about why more trouble might lie in store. But letting this influence your portfolio decisions probably isn’t beneficial, in our view. Based on our research, if you can identify a bear market—a typically lasting, fundamentally driven decline exceeding -20%—early enough, taking action can help, allowing you to sidestep some negativity and buy back in at lower levels later. (More on this to come.) But sentiment-driven wiggles are historically much more common, given that we have had just 5 bear markets since 1982 versus those 55 pullbacks and corrections. We think timing short-term, sentiment-driven swings is flawed strategy, as you could be selling after a decline, locking in losses in fear of further bigger declines later. Those may come, perhaps offering momentary comfort, but in our view, a better option is to think of your time horizon—the period you need your portfolio to reach your investment objectives.

In our view, equity investors should have longer time horizons than just a few years, and moving to the sidelines can set your financial goals back. Investors timing near-term volatility might miss gains if they make their exit or re-entry into equities incorrectly, which can jeopardise longer-run returns. We think this is an unnecessary risk. Our research indicates sentiment-driven market moves—including periodic volatility, pullbacks and corrections—are usually short-lived next to bull markets’ long-term upward trend.^[iii] Global equities’ long-term returns, 11.0% annualised, include all of them.^[iv] Staying invested through occasional dips is generally the way to go, in our view. But we recognise in the moment, it can be extremely hard! This is why we think it helps to go through past episodes once in a while as thought experiments.

Consider a couple of recent bull market wobbles. The lastest drop exceeding -5% occurred last October, when the MSCI World Index fell as much as -6.5%, tied to commentators’ warnings of a second COVID wave and uncertainty stemming from America’s election.^[v] But after November’s vaccine progress announcements (and America’s election), markets erased the decline. Before then, there was late-2018’s deep -16.3% correction, which commentators we follow argued was caused by US Federal Reserve rate hikes, rising sovereign debt yields, US-China trade tensions or weak economic data.^[vi] In our view, a raft of hedge fund liquidations was the primary culprit, which weighed on sentiment. But like all sentiment-fuelled moves we have found in our research, it proved fleeting despite the magnitude. To us, the best course of action is to soldier through the fraught headlines and blaring alarms that typically accompany such cases.

Most of the time, equities aren’t making new highs day in and day out, even in the strongest bull markets.^[vii] Look at any line graph of a bull market, and you will see it isn’t a straight ride up—it is jagged. Shares always zig-zag. Just as the upward zigs during a bear market can lull people into complacency, the downward zags during a bull market can stoke fear. But how do you discern a bear market from a bull market correction, especially in the early stages? First and foremost, according to our analysis, bear markets start one of two ways: either widespread euphoria inflates expectations and blinds investors to broadly worsening economic conditions, or a hugely negative bolt from the blue wallops the global economy into recession. In our view, last year’s global lockdown was a wallop, whilst the 2000 dot-com bubble was classic euphoria. In both cases, we think there is a wide gap where expectations overran reality; a bear market closes the gap and then some.

Early on though, before an identifiable cause is obvious, markets may be zigging and zagging without clear direction. We think following a few bear market rules can help investors identify them—and avoid mistakenly identifying them:

1. The 2% rule: Bear markets characteristically begin with rolling tops, in our experience. At their start, they often decline gradually, on average by -2% a month. We think sharp, sudden dives, whilst scary, typically rule out a bear market, with last year being the exception.
2. The three-month rule: Even if you suspect the bull market has peaked, we suggest waiting three months before taking defensive action. Can you identify a fundamental cause few others see? Is the pace of decline gradual or swift? In our view, the first question is core to whether you have a reason to take action; the latter can help you discern typically swift corrections from normally gradual bear markets.
3. The two-thirds/one-third rule: Ordinarily, based on our analysis, about one-third of a bear market’s decline occurs during the first two-thirds of its duration, whilst the most damage, around two-thirds of it, occurs in its final third.

Otherwise, we think a simple maxim holds: If we can’t conclude that it is a bear market, we approach it as a bull market.

We think the key for investors is being invested when equities are forging higher—like now, when the MSCI World is up 17.3% on the year.^[viii] In our view, that means staying in the market during run-of-the-mill volatility—or corrections.^[ix] Being out when the market is up can not only incur opportunity costs—missed returns that could have improved progress toward your investment objectives—but mental ones as well. Missing upside may be just as painful as experiencing declines.

Whilst it can be beneficial to try and cut out part of bear markets’ downside, as we think last year showed, doing so isn’t necessary in order to reap equities’ longer-term returns. In our view, investors’ biggest risk isn’t a bear market—much less pullbacks or corrections—but not attaining their financial goals. We think achieving market-like returns to fund retirement and other expenses generally requires being invested in equities the vast majority of the time.

In our view, enduring volatility and pullbacks when they come is critical to long-term investing success. We think it is better to absorb that lesson now to help withstand rocky patches when they occur.