Markets Go Down Sometimes
Markets do go down sometimes. After a long run of record highs, volatility has returned, with the S&P 500 dropping nearly 4% in a week. The catalyst this time is a familiar one: rising interest rates and looming inflation.
Source: Bloomberg, 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
The yield on the 10-year bond, which as recently as September was just over 2%, was at 2.85% in the first week of February. Wages are finally showing signs of life, up 2.9% from the prior year, according to the Labor Department – the best growth since 2009. The Federal Reserve continues on its course of raising rates, with a minimum of three bumps to the Federal Funds Rate anticipated for the year.
All of this served to spook both the bond and the stock markets, with a sell-off starting in the U.S. and then reverberating around the world. Matters weren’t helped by a report that the federal government may borrow as much as $1 trillion during the current fiscal year. A few asset classes have been spared so far, including alternatives, which have historically avoided around 91% of the losses from market downturns, as measured by the returns of the Credit Suisse Hedge Fund Index. For the period 1994-2017, there were 105 months when the S&P 500 was negative. In 96 of those months, alternatives broadly outperformed.1
Economist Herbert Stein famously noted, “Something that can’t go on forever, won’t.” That’s easy enough to grasp intellectually, but it’s hard sometimes to not get caught up in the excitement of the moment. Exhibit A: the wild run-up (and down) of Bitcoin over the last several months. While there has been a lot of talk about the potentially disruptive effects of digital currencies and the blockchain, the “coins” themselves can be highly volatile and difficult to value on anything like a fundamental basis.
Source: Bloomberg, 2018.
Stocks and bonds have at least established metrics for determining some kind of value. But of course, that can change quickly, too, especially when rising interest rates start to pressure risk assets generally. This brings us back to a familiar theme: the role alternatives can play in an investment portfolio. Properly diversified, an allocation to this asset class can help manage overall portfolio volatility, while providing continued exposure to the markets. That, in turn, can help address one of the true wild cards in investing: individual human behavior.
As we all know, it’s hard to not chase returns when markets are setting new highs, and it’s tough to stay the course when they start to correct. This is in spite of the fact that virtually no one is able to time the market on a consistent basis. The problem with timing is you have to be right twice – getting out and getting back in – or you end up sitting on the sidelines when markets start to recover.
It’s worth remembering, too, that volatility isn’t always risk – the former generally reflects transient changes to asset prices, while the latter refers to a permanent loss of capital – but it’s hard to convince yourself of that during a correction. Volatility feels like risk, and many investors respond accordingly. So, dampening volatility can also slow the impulse to react. Yet another reason to consider including alternatives in a portfolio.
1. Bloomberg, as of 12/31/17.
All investments are subject to risk and will fluctuate in value. Past performance is not indicative of future results. An investment cannot be made in an index. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government as to the timely payment of principal and interest.
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S&P 500 Index is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
Credit Suisse Hedge Fund Index is an asset-weighted hedge fund index and includes open and closed funds.
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