Still Keeping A Steady Hand

By Preston McSwain, October 7, 2022

The title of this post comes from a piece that we wrote almost exactly this time seven years ago. It spoke about a message that I got from my then 10 year old son. As the picture above shows, he is no longer 10 but the lessons about how to navigate choppy waters (sailing then and rowing now) remain the same.

Below are our most recent related thoughts on the market, which are excepts from our quarterly letter.

Throughout and at the bottom under Related Reading are links to other messages we have sent to our partners, to include the post I mention above.

Simply put, neither the stock market nor the bond market is having a good year.

After the end of the second quarter, a strong rally carried the global equity market up almost 14% off its prior lows by the middle of August. Since then, however, it has fallen again, and was down approximately 25% year to date as of quarter end.

Bonds also rallied strongly and then fell back this past quarter. While they have outperformed equities by a large margin on a relative basis, municipal bonds were down approximately 8% year to date.

I mention these large up and down moves not to increase concern, but to underscore a point we have made many times before:

Volatility, sometimes extreme, is a market feature, not a bug.

To test this view, we asked a quantitative researcher we often collaborate with to help us create the following long-term illustration of daily returns – it covers almost 140 years of data.

U.S. Stock Market: Daily Fluctuation of Returns and 200 Day Moving Average
(February 1885 – July 2022)

Source: Alpha Architects compilation of data sets from Schwert and French.

Looking at this illustration, you can clearly see the big volatility spikes in 2020 on the right-hand side, followed by the increases that have happened this year. It is more difficult, though, to make a case that recent volatility is substantially different from other periods of distress.

Viewed another way, below is a histogram that depicts the distribution of daily returns from the first half of this same 140-year period on top of the distribution of daily returns for the second half. They are hard to distinguish from one another.

U.S. Stock Market: Histogram of 200-Day Moving Average Returns
(February 1885 – July 2022)

Source: Alpha Architects compilation of data sets from Schwert and French.

Market dynamics have changed dramatically over the past 100 years (high-frequency trading, broad access to information, the speed at which larger numbers of investors can analyze data, etc.)

But…

One thing remains the same. Markets are chaotic.

On the positive side, even though market drops occur frequently, they often create opportunities for compounding returns off of a pull-back.

By way of example, the following is a long-term view of the growth of $10,000 invested in the U.S. stock market (in green), illustrated above the large percentage drops off market tops that have consistently occurred along the way (in red).

Stock Market Growth with Intra-Period Declines from Market Tops
(S&P 500 Total Cumulative Return – January 1950 – September 2022)

Sources: YCharts and S&P Dow Jones Indices

Since we founded FWP over a decade ago, we have not gone a single year without writing about a large market drop, and then commenting on what history has consistently shown is the key to successful long-term investing (see examples below under Related Reading).

Our experience, and that of many others, has been that we make better decisions if we resist spending too much time on what we cannot know (what the future will bring) or cannot control (the next market event and how investors will react to it), and more time taking a long and steady view. Along these lines, the following are recommendations we made in a letter almost exactly this time seven years ago.

Have A Long-Term Plan That Is Designed to Meet Your Individual Goals
- Investing should not be a competition
- Unless your goals have changed, do not throw out a good plan with a bad market

Be Contrarian and Don’t Follow the Herd
- Wall Street and Federal Reserve predictions are often wrong
- Large flows into and out of an asset class are often a sign of a top or bottom

Keep It Simple – Slow, Steady, and Boring Often Wins
- The tortoise consistently beats the hare, often with significantly less heartburn

As we mentioned in our last note, the U.S. stock market is positive on a calendar year basis approximately 80% of the time, with average 10-year returns of well over 12% per year. In addition, as the chart below highlights, the market has rewarded investors handsomely for staying disciplined after large drops.

Cumulative Returns After Market Drops
(1926 – 2021)

Source: Dimensional Funds, period July 1, 1926, through December 31, 2021

This year may well not be among the 80% of positive years and forward-looking returns may not be as attractive as in the past. History has consistently shown, however, that investors can produce attractive returns and reach goals by focusing on the bullet point recommendations and the high probabilities of market growth we mention above.

Staying disciplined in our own approach, if the market takes portfolios too far off investment policy targets on the downside, we will buy, not sell, to stay in line with long-term policy targets. In addition, we will continue to prudently evaluate higher probability tactical opportunities and take advantage of them when they present themselves.

We will make mistakes and will not always rebalance or make tactical moves at the optimal moment, but by sticking to our process, we think we remain in a good position to add value with reasonable levels of risk.

As always, if you have any questions or would like to have a review call, please call us anytime.

Related Reading:

Inversions – What Investors Should Do – April 2022

The Same Thing – Over and Over – October 2021

What Should Investors Do During Crisis Moments? – March 2020

Every Day Can Not Be Good – September 2019

Holiday Colors – December 2018

How Should You Invest Now – January 2017

What To Do About… ? – July 2016

Keep A Steady Hand on the Tiller – September 2015