A Rare Do-Over For Equity Investors? by Jay Leopold, Columbia Threadneedle Investments
- While the market may still rally to new highs, the late August free fall in stock prices and spike in volatility served as a wake-up call for investors.
- In the past ten weeks, major equity indices have recovered virtually all the losses experienced during the August swoon.
- The recent rally gives investors a second opportunity to position their portfolio for an important inflection point in monetary policy as the Fed likely starts raising interest rates.
The Merriam-Webster definition of do-over is “a new attempt or opportunity to do something after a previous attempt has been unsuccessful or unsatisfactory.” How many times in life have you longed to revisit an unfortunate or unwise decision, essentially wishing for a do-over? Maybe it was that email you sent? That spicy meal you ate? With a little thought, each of us could compile a long list. This is especially true in the highly competitive and constantly evolving world of investing.
The spring and summer months were cruel to many areas of the capital markets, as commodities, the dollar, credit spreads and emerging markets began to discount the beginning of a tightening cycle by the Federal Reserve. U.S. equities were a notable exception as of mid-August, as equity valuation levels and major indices remained near all-time highs.
But in a seeming blink of an eye, equities joined the wave of de-risking that gripped many markets, with the S&P 500 tumbling a stunning 11% in the space of several days in late August. While some portfolios were reasonably well-positioned and outperformed their benchmarks, this downdraft was wholly unsatisfactory to many investors.
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In the past ten weeks, major equity indices have recovered virtually all the losses experienced during that dizzying plunge. Risk appetites have generally returned to pre-swoon levels, as seen in Exhibits 1 and 2 depicting valuation levels and the volatility index (VIX). While bond markets have recovered a bit since late August, fixed income investors remain generally skeptical, with spreads wider (risk-averse) than last spring (Exhibit 3 and 4).
Events have unfolded to give equity investors a rare do-over: a new opportunity to re-visit a past decision regarding portfolio risk. We are not suggesting the market will plunge, but that the recent rally provides a second opportunity to position your portfolio for an important inflection point in monetary policy as the Fed likely starts raising interest rates for the first time since 2007.
The future is always uncertain, and a bull and bear case for stocks can be made. Some bulls argue that the widening of spreads is discounting several impending hikes and that spreads will come back down after the Fed acts. While possible, this theory depends on several “ifs” that may or may not occur. Second, bulls posit that the initial hikes of a tightening cycle won’t do enough to harm the economy and actually signal solid expected economic growth. A reasonably steep yield curve currently supports this argument.
The bear case remains roughly the same as it was in mid-August: equity valuation levels are high in absolute terms and appear somewhat out of step with the recent deterioration in fixed income, commodity and emerging markets, where investors remain relatively cautious. This suggests further multiple expansion will be more difficult from here. In addition, the economic expansion is seven years old, and may be much closer to the end than its beginning. Finally, the unwinding of the unprecedented easy monetary policy could have some unforeseen consequences.
Investors need to take risks to achieve their objectives. The key is to get adequately compensated for those risks. While the market may still rally to new highs, the late August free fall in stock prices and spike in volatility served as a wake-up call. Investors who were not properly positioned and frustrated by their performance in the late August swoon are being given a do-over to reposition their portfolios in a manner that creates the proper balance relative to their long-term return goals and risk tolerance.