Because human beings are involved in financial markets and human beings are controlled by the still-primitive "fight-or-flight" behavioral response when faced with stressful situations, financial markets can forever oscillate between complacency and volatility.

Lately the recent moves from complacency to volatility and back again seem to happen quicker but are probably not any quicker than the rate of normal long-term volatility. Given the incredible 10-year bull market ride, it is easy to forget that markets can go down. And go down often. And go down a lot!

There are five important things to remember at these moments:

  1. Financial markets are cyclical. Despite the shockingly long period of complacency (or the lack of very significant equity market sell-offs) since 2009, equity markets have a tendency to correct (go down) by over 10% (peak to trough) in about 50% of any annual measurement period. This has been the case since 1950 using the S&P 500 Index as a proxy. As a reminder, we have had a handful of 10% corrections since 2009 and low and behold we survived! We will have more of those in the future. To put things in perspective, as of yesterday’s market close, the S&P 500 Index and the MSCI All Country World Index, equity indices comprised of U.S. and global stocks, respectively, were down about 6.25% from their most recent highs in late July.  We are not suggesting this is insignificant, but equity markets were at or near all-time highs in late July, and at this point, 6.25% may not be as bad as what some perceive is happening if they are just watching financial news media “Special Reports.”
  2. "Bear" markets, technically defined as a 20% correction, happen and can happen again. Since 1962 there were 46 previous declines of 10% or more, and 19 of those corrections became bear markets. Will this one turn into a bear market? We don't know. But it can happen at some point in the future. Steel yourself now.
  3. In the grand scheme of things, the short-term volatility we experience from time to time is nothing more than a blip. Given a long-term investment horizon, an investor may not remember these bouts of market turbulence 10, 20 or 30 years from now. We can almost guarantee it.
  4. Reacting emotionally to the downside volatility and not sticking to your financial plan in the short-term can be a long-term mistake. A decision to sell during times like these can make the pain, anxiety and sleepless nights go away, but so can drinking a lot of bourbon. Both work in the short-term but both can also cause problems in the long-term and are probably not a great idea. By selling, you realize a permanent loss of capital immediately and forgo the likely move higher in the future.
  5. Howard Marks, legendary investor and author of one of our all-time favorite investing books The Most Important Thing: Uncommon Sense for the Thoughtful Investor, puts these moves between complacency and volatility into great perspective:

"The bottom line is that investor psychology rarely gives equal weight to both favorable and unfavorable developments. Likewise, investors’ interpretation of events is usually biased by their emotional reaction to whatever is going on at the moment. Most developments have both helpful and harmful aspects. But investors generally obsess about one or the other rather than consider both...It all seems so obvious: investors rarely maintain objective, rational, neutral and stable positions. First, they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting behavior causes asset prices to rise, potential returns to fall and risk to increase. But then, for some reason – perhaps the arrival of a tipping point – they switch to pessimism, fear, risk aversion and skepticism, and this causes asset prices to fall, prospective returns to rise and risk to decrease. Notably, each group of phenomena tends to happen in unison, and the swing from one to the other often goes far beyond what reason might call for.”

In Marks' words, clearly the investor psychology and emotional reaction to the events at hand have become very pessimistic, fearful, risk averse and skeptical all at once.

Why you ask?

Well, we never truly know the answer to that question.

But we do have some ideas that we outlined in our Q3 2019 Capital Markets Outlook.

Today's market consternation may be due to the Federal Reserve Bank's monetary policy tightening over the last two years coupled with trade tariff uncertainty and its unintended consequences on global corporate earnings. This combination is slowing the economy down…and therein lies the problem.

The previous two slowdowns still had the Fed’s monetary policy positioned as a tailwind, i.e. short-term interest rates were close to 0% and financial conditions were loose. Today the Fed is a headwind and may be on the verge of making a monetary policy mistake and sending the economy into a recession by being too tight at the wrong time. The evidence for this mistake can be found in the “inverted” U.S. Treasury yield curve. This is a rare occurrence when short-term (3-month, 1-year, and 2-year) U.S. Treasury securities' interest rate yield is greater than long-term (10-year) U.S. Treasury bond interest rates yield. Normally 10-year U.S. Treasury bonds yields are greater than short-term U.S. Treasury security rates; rightly so since investors normally demand a higher return for loaning their money to the government for a longer amount of time.

We believe that an inverted U.S. Treasury yield curve is always a sign of a monetary policy mistake by the Fed and usually a warning of a recession in the future (i.e. within the next 12 months). That’s because monetary policy mistakes came in all shapes and sizes in the past, and the magnitude and duration of the mistake are critical pieces factoring into whether a recession occurs thereafter. So far, this policy mistake has been small by historical standards. If the Fed can correct the mistake in time – by lowering short-term interest rates immediately and adequately, a recession may be avoided. Unfortunately, the Fed does not have a strong track record on this outcome when in rate-hiking mode, achieving a “soft landing” after raising rates only three times in the last 100 years.

We, along with everyone else in the world, cannot accurately or consistently guess the direction the market will move next this time around – it could be up, down or sideways. We simply do not know, and we do not have a crystal ball. One thing we know for certain is that emotion and fear have returned in the markets, and when that happens capital markets usually become divorced from their underlying financial fundamentals.  With sound financial plans in place, we do not think that any drastic action should be taken.  Ongoing discussions with advisors should continue to focus on what is the appropriate asset allocation for each individual investor.

In light of the recent trends in the market, the Sequoia Team has been hard at work, proactively developing resources to help you keep pace with the ever-changing economic landscape.  Our latest endeavor is the Recession Opportunity Kit. We have whitepapers, videos, podcasts and more resources available to help you prepare. As always, please contact an advisor if you have any questions.

Click here to access our Recession Opportunity Kit resources.