Five 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.”

The task is a precarious and generally thankless one, especially when it comes to financial markets, not least because no-one – but no-one – has a crystal ball.

Positive forecasts can easily come unstuck and then be subject to ridicule. Just ask the highly-respected and very shrewd economist Irving Fisher who argued in October 1929, less than a fortnight ahead of the Wall Street Crash, that “Stock prices have reached what looks like a permanently high plateau.”

Negative or bearish forecasts are rejected as the work of a tiresome Cassandra or tend be blamed if something does go wrong, rather than thanked for their shrewdness.

The market stumble witnessed on Friday of last week and Monday of this week had been overdue – the combination of record-high indices, record low volatility and rising interest rates (in the US and even the UK) was not 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 14:30 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.

Even so, calling the precise timing of the downward move was, as ever, nigh-on impossible.

More pertinently, investors must decide what to do now and there are five 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 14:30 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 relying on the trappy combination of timing the market and using market liquidity to do so.

Investing is not about timing the market. It is about turning time into money, through the patient harvesting and reinvestment of dividends, which are themselves the result of having identified companies with strong competitive positions, pricing power, good margins, competent management, sound balance sheets and strong cash flow. And the benefits of compounding dividends take a decade and more to really emerge.

Trading is trying to time the movement of money, second-guess where it is going and take a punt, with little or no particular concern for the underlying quality of the assets involved.

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”.

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 click of a mouse or swipe of a finger. It is about being able to buy or sell what you want, when you want and – most importantly – in the volume you want and at the price you want.

There will usually be a bid but in a falling market if 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.”

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.

In technical terms, a 10% drop is an official correction, a 20% drop a bear market. As of 1430 on Tuesday, the Dow Jones was 9% off its highs and the FTSE 100 was 8% below its January peak.

As such, some context must be maintained.

The US has seen 4 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 8 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 14:30 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 14:30 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.

5. In sum, check your portfolio and the risks involved, not just the potential rewards

Buffett uses the dictionary definition of risk, namely “the possibility of harm or injury” and in a financial context this means losing money, your willingness to take that on and ability to withstand it.

If the market gyrations of earlier in the week made you feel uncomfortable then it is possible you have unwittingly taken more risk in your portfolio than you really feel comfortable with.

It may be worth sitting down and assessing where you do feel comfortable and where you do not, either on your own or with a financial adviser, to ensure your portfolio is properly set so that it fits with your overall strategy, target returns, time horizon and appetite for risk.

Russ Mould, AJ Bell Investment Director