Four lessons to learn from the market meltdown

As the legendary US baseball player Yogi Berra once noted: “It’s tough to make predictions, especially about the future,” although many advisers and clients would doubtless argue that the market stumble witnessed on Friday of last week and Monday of this week had been long overdue.

After all, the combination of record-high indices, record-low volatility and rising interest rates (in the US and even the UK) was hardly an ideal one.

The US has lost all of its 2018 gains, the UK has gone back to April 2017 levels

Source: Thomson Reuters Datastream. *As of 1430 on Tuesday 6 February.

Indeed, the mill-pond like stock market calm of the past two years has been highly unusual relative to history and when we have seen similar periods in the past they have tended to herald periods of greater volatility (but not necessarily immediate or sustained drops in key benchmark indices).

Volatility has spiked in the USA and UK after a period of remarkable calm

Source: Thomson Reuters Datastream.

Advisers and clients must decide what to do now.

There are four lessons which can be drawn from the revival of volatility, all of which could be useful when it comes to asset allocation, portfolio construction and strategy going forward.

#1. Cracks are appearing in the markets

Like any structure, markets have their weak points and the pressure begins to tell here first, before it slowly creeps in from the periphery and less important arenas to more important, core ones.

And cracks can be seen in certain areas where market action has been particularly speculative – and thus prone to an accident.

  • Uber had a ‘down-round.’ The much-hyped, heavily loss-making technology developer (or taxi service, depending on your viewpoint) raised capital in a private deal which saw its implied valuation fall from $68 billion to $48 billion. Drops of 30% like that aren’t supposed to happen in bull markets to hot-property companies.
  • Heavily-indebted companies are coming under pressure. Carillion is a classic example but retailers on both sides of the Atlantic are struggling to service their debts or meet lease payments, even though taking on both looked smart when all was going well. Now times are tougher, problems are appearing, as Toys ‘R’ Us, Debenhams and others will attest.
  • Most spectacularly, Bitcoin buyers have encountered trouble. The cryptocurrency has – for the moment at least – stuck to the script outlined by market historians who looked at prior market bubbles such as seventeenth-century tulip bulbs and twentieth-century tech stocks. Bitcoin has plunged from $18,000 to $6,200 and the total loss on all 1,500-plus cryptocurrencies listed on www.coinmarketcap.com has reached over 50%, or $350 billion in 2018 to date.

Bitcoin has suffered sharp losses in 2018

Source: Thomson Reuters Datastream. *As of 1430 on Tuesday 6 February.

#2. Don’t try to time the markets

Stories of US private investors finding themselves unable to trade when they wanted, or at all, on Monday 5 February, were no surprise, as markets can and do seize up when put under duress.

This is a timely reminder of the dangers of trying to time the market.

As legendary US investor Warren Buffett once noted, “If you aren’t willing to own a stock for 10 years, don’t even think about it for 10 minutes”.

This maxim could just as easily apply to a fund, active or passive.

If this weeks gyrations have made advisers or clients uneasy, then it may be worth sitting down and assessing where they feel comfortable and where they do not, to ensure that portfolios are properly set so that they fit with the overall strategy, target returns, time horizon and appetite for risk (which is best defined as the willingness and ability to withstand near-term loss in pursuit of long-term gain).

#3 Don’t rely on liquidity

Buffett’s insistence on a long-term approach is based on avoiding each of costly trading fees and commissions, the need to predict unpredictable short-term money flows and also a reliance on market liquidity when you need it.

Liquidity is not just being able to buy and sell at the click of a mouse or swipe of a finger. It is about advisers and clients being able to buy or sell what they want, when they want and – most importantly – in the volume they want and at the price they want.

There will usually be a bid but in a falling market it may be lower than you want or need, so assuming you can always get what you want could prove dangerous.

As J.K. Galbraith put it in his book The Great Crash 1929: “Of all the mysteries of the stock exchange there is none so impenetrable as to why there should be a buyer for everyone who seeks to sell. October 24 1929 showed that what is mysterious is not inevitable. Often there were no buyers and only after wide vertical declines could anyone be induced to bid. Repeatedly and in many issues there was a plethora of selling and no buyers at all.”

Advisers and clients are unlikely to be taking on the challenge of buying or selling individual stocks but the 2016 freeze in some commercial property funds, for example, may still be fresh in the minds of some.

#4. If you think this is volatility, you haven’t seen anything yet

While Monday’s 1,175-point drop in the Dow Jones Industrials was the biggest fall on record in terms of points, it was nowhere close in percentage terms.

The US index may have lost ‘just’ 508 points on Black Monday in October 1987 but that equated to a 23% drop. And a mere 38-point plunge on Black Monday in 1929 meant a 13% drop, as part of a crushing string of downward movements which comprised the Crash of that year.

As such, some context must be maintained.

The US has seen four days already in 2018 when the S&P 500 index moved up or down by more than 1% during a trading day. It managed that just eight times in 2017. And it managed it 137 times in 2008 (or more than one such change for every two days), including 55 moves of between 2% and 5% and 18 of more than 5%.

As can be seen from this chart that compares the number of 1%-plus moves per month with the S&P 500, markets do best when they are calm, although extreme volatility can be a buy signal. Moreover, an increase in volatility in 1998-2000 and 2005-07 did not prevent further gains, although the build-up did herald an eventual smash.

Volatility in US stocks still stands at two-year lows

Source: Thomson Reuters Datastream. *As of 1430 on Tuesday 6 February.

The same pattern can be seen in the UK’s FTSE 100 and its relationship with volatility.

Volatility remains low by historical standards in the UK, too

Source: Thomson Reuters Datastream. *As of 1430 on Tuesday 6 February.

If history repeats itself (and there is no guarantee that it will) then markets could become a lot wilder, even if they could still advance further before they finally hit the wall.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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