Are You Prepared for Choppier Waters?

By Craig Fehr March 01, 2018

Ocean lighthouse

Market's sailed through much of the past two years with relatively little rock in the boat. However, we expect more waves moving forward. To be clear, we don't think the market's boat will spring a leak, but as we move ahead in 2018, we think investors face a choppier ride. And, with volatility spending much of the past two years near historic lows, we recommend a proactive approach to position for – and potentially benefit from – bigger swings in the market.

Smooth sailing – It's been more than 20 months since the last 5% selloff and the last 10% correction was over two years ago.1 The VIX index, which measures market volatility, recently reached the lowest level on record. This is hardly a bad thing, particularly since this tranquility was accompanied by double-digit average returns from Canadian, U.S. and overseas stock markets over the past two years. But low volatility: 1) won't last forever, and 2) can foster complacency that causes overreactions when market fluctuations emerge.

VIX Index
Spikes in Market Volatility Have Been Good Buying Opportunities

VIX Indexchart

Sources: Bloomberg & Morningstar Direct, 1/16/2018. Stock market total returns for the S&P/TSX Composite, S&P 500, and MSCI EAFE Index in local currency. Past performance is not a guarantee of how the market will perform in the future. Indexes are unmanaged and are not available for direct investment. All returns expressed in local currency and include reinvested dividends.

A list of wave makers – We think spurts of volatility will become more frequent, and the potential for a market correction – which would be just the third since 2011 - has risen. As central banks – especially the U.S. Fed – gradually withdrawal stimulus, stocks could be more prone to knee-jerk reactions to disappointing news, including weak economic readings (particularly in the U.S. or China), a drop in oil prices, unexpected weakness in the Canadian housing market, a downturn in China or increased conflict with North Korea. We think the Bank of Canada will move more slowly in tightening policy, but since 1980, in years when the U.S. Fed raised rates three times or more, stocks experienced an average of four 5% pullbacks and one 10% correction.2

Swaying, not sinking – Market declines never feel good, but not all pullbacks are created equal. When markets dip in response to short-term disruptions, political uncertainties or sensational headlines, these can be attractive buying opportunities when the fundamental underpinnings of the market remain intact. Currently, these underpinnings include ongoing expansion in the domestic economy, a synchronized and improving pace of growth globally, rising corporate earnings and still-relatively low interest rates. We think these conditions will remain in place this year, making pullbacks – though more prolonged and material than we've experienced in recent years – temporary and an opportunity for long-term investors.

Declines in the Canadian and U.S. Stock Markets By Decade

Declines in the Canadian and U.S. Stock Markets By Decade chart

Sources: Ned Davis Research, 1/1/1950 - 11/30/2017. The Dow Jones Industrial Average and S&P/TSX Composite are unmanaged indexes and cannot be invested in directly. TSX performance based on available daily historical data.

Preparation prevents motion sickness. Volatility is inevitable, and in our view jumping in and out of the market to avoid it is not a sound strategy. Instead, to prepare, we recommend the following:

  • Reassess. Review your portfolio to ensure it is still in alignment with your goals and risk tolerance.
  • Reset. Take the opportunity to reset reasonable expectations. Canadian and U.S. stocks have delivered average annual returns of 20% and 22%, respectively, over the past two years. We think equities will provide positive, but more moderate gains as we progress in this cycle, and the path to those gains will be choppier.
  • Rebalance. If the rally in stocks has made them a larger-than-intended portion of your portfolio, we recommend rebalancing back to your target mix. This can help reduce your sensitivity to fluctuations in stock prices.
  • React. Against the backdrop of improving fundamentals, including positive economic growth and rising corporate earnings, we believe the broader path for the markets remains higher, creating attractive buying opportunities. Having a strategy in place in advance of a market pullback will put you in a better position to capitalize on it, if  appropriate.

Important Information:

Sources: 1. Ned Davis Research, performance of the S&P 500 Price Index. 2. Federal Reserve Economic Data & Ned Davis Research. Past performance of the market is not a guarantee of how it will perform in the future.

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