Beating The Fear Factor In Equity Markets by Sharon Fay, Alliance Bernstein

Today’s equity markets have all the makings of a scary movie. But don’t look away. Embrace uncertainty and adjust expectations to regain conviction in equities as a source of long-term returns.

There’s no shortage of worries for equity investors this year. January’s spike in volatility has scarred the market. The global economic growth outlook is shaky amid China’s slowdown. Stock valuations look full, and earnings are under pressure in a low-growth world. And there’s growing concern that if Britain votes to leave the European Union on June 23, markets could take another hit. No matter what type of investor you are, it’s hard to know how to proceed.

Adjusting Return Expectations

Start by adjusting expectations. After the global financial crisis, easy money policies from the major central banks fueled a multiyear rally in equities. As a result, valuations reached relatively high levels, particularly in the US, where the market’s price/earnings ratio (P/E) was 16.7 at the end of May—higher than in 64% of all months since 1996. European P/Es are lower, though slightly above their long-term average. Emerging markets, however, are still attractively valued after five difficult years.

But looking at valuations in isolation is misleading. For perspective, it’s important to assess the potential of equities in the coming years versus other investing options—and what’s likely to drive returns.

Since the global financial crisis, investors have become accustomed to unusually strong equity returns, with the S&P 500 advancing by an annualized 17.3% from 2011 through June 2015, driven by a recovery from a crash of historic proportions. But the recovery started to run out of steam last summer, and these returns aren’t likely to continue.

At the same time, fixed-income returns are also likely to remain low. Our Capital Markets Engine, which projects 10,000 possible outcomes based on a variety of market conditions, expects the S&P 500 to return an annualized 5.9% over the next five years (Display). That’s much lower than in the past few years, yet still well above our projections for investment-grade fixed income. This outlook highlights why maintaining an allocation to equities is vital for investors to meet their long-term goals, in our view.

Fear Factor In Equity Markets

The composition of returns is also changing. In the first few years of the recovery, equity returns were driven primarily by earnings growth, as companies cut costs dramatically in response to the recession and increased their operating margins. From 2012 to 2015, equity returns were fueled mostly by rising P/E valuations. Over the next decade, our forecasts suggest that earnings and dividend growth are likely to drive equity gains, while multiple expansion will probably be modest.

Preparing for Volatility

Yet even with this context, volatility remains a big deterrent for many investors. From economic growth concerns to regulatory changes and political risks, fears of instability are pervasive.

We think investors should cope with volatility by embracing it. Volatility isn’t going away. But by accepting volatility, you can avoid making hasty and damaging decisions when turbulence strikes.

The first quarter of the year provides an excellent example. Equity markets around the world fell by more than 10% from January 1 through February 11, then rebounded sharply through March. By quarter-end, most of the sharp declines had been reversed. Investors who sold positions in mid-February would have locked in painful losses. But if you accept that volatility is a factor of life, it’s so much easier to be prepared, to keep your cool when markets get rough—and to stick with an investing strategy.

Three Reasons to Stay Active

With so many challenges, it’s tempting for some to stay on the sidelines or choose passive investing solutions. We believe this is a mistake for three reasons.

First, passive portfolios aren’t risk free. It’s a common misconception that going passive means eliminating risk. While an ETF does reduce the relative risk of underperforming a benchmark, it does nothing at all to mitigate absolute risk. So when markets are tumbling, an ETF that invests in the broad market has no way to offer protection. What’s more, benchmarks are often prone to concentration risk, when a sector or industry becomes too big or too small for the wrong reasons.

Second, since returns will probably be relatively low compared to history, beating the market—even by a small margin—will be especially important for investors to meet their goals. Over a 10-year period, adding two or three percentage points to annual returns can make a difference of up to 32% in the cumulative return of a portfolio (Display).

Fear Factor In Equity Markets

Third, as economic growth rates and policies diverge between regions, the opportunities for active managers to select among winners and losers improve. Similarly, technological and regulatory change is creating uncommon opportunities that can’t be captured effectively in an index.

Of course, active managers continue to face scrutiny on several fronts. That’s why investors should make sure that the fees they are paying are well spent on active managers who don’t hug the benchmark, have capacity constraints to invest effectively and use a disciplined process backed by robust research to facilitate skillful stockpicking.

With these points in mind, investors can find active strategies suited to their risk appetites and return objectives, which should do well over the long term, even in an environment of lower returns. In a volatile world driven by short-term impulses, beating the fear factor to invest in equities for long-term success really comes down to mind over matter.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

The Bernstein Capital Markets Engine uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation rate and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist between the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.