True North Capital Alliance Logo

Observations About Recent Market Volatility

Marcus Winbush, CFP® — Senior Financial Planner, CEO

We Should Expect Volatility

Given the state of recent market volatility, it is important to recall how well-functioning capital markets work and what prices reflect. Prices reflect the aggregate expectations of market participants. Risk aversion, investors’ tastes and preferences, and expectations about future profits are among the many inputs that affect aggregate expectations. We should expect these inputs to vary day-to-day. Markets adapt to changing expectations and new information. As a result, we should expect both prices and the level of volatility to fluctuate. Consider the alternative: If prices remained constant and did not adjust, we would be concerned that markets were not functioning properly. Of course, returns have been anything but static thus far in 2016. Now we are left to consider whether the returns we saw in January provide information about returns for the remainder of the year.

As we would expect over any period, prices in January 2016 changed from day-to-day as aggregate expectations changed and investors processed new information (e.g., downward pressure on oil prices, changes in China’s equity market/economy, changes in global financial markets, etc.). During the month, the S&P 500 Index had a return of −4.96%, the ninth lowest return for the Index since 1926. S &P 500 returns for the first two weeks of January were the worst start of the year in S&P 500 history, with the index returning −7.93% from January 4–15, 1916. Based on this information, some investors may wonder whether the S&P 500 Index returns in January have some predictive power for the returns to be expected for the remainder of the year.

A comparison of January returns versus the February-December returns for 1926-2015 is very revealing. This comparison shows that a negative January was followed by a positive return for the subsequent 11 months 59% of the time, with an average return of 7%. Thus, a negative January does not predict poor market returns for the rest of the year. Moreover, if we look at the five lowest January returns in 1926-2015, the average return for the remainder of these years was 13.8%, and none of these years finished in the lowest 20 years of annual returns for the S&P 500 Index.

What Can We Learn from Previous Market Declines?

As mentioned above, the return for the S&P 500 through January 2016 was −4.96%. From its high on November 3, 2015 through its low on January 15, 2016, the S&P was down −10.43%, its second decline of at least 10% since the beginning of August 2015. We can look at the data in Exhibit 1 to see how the U.S. market performed in subsequent periods following different magnitudes of decline. The exhibit looks at previous times when the S&P Index declined by 10% and 20% and shows the subsequent 1-, 3-, and 5-year return.

Exhibit 1: U.S. Large Cap for January 1926-December 2015
Cutoff for DeclineFrequency of Such DeclinesAnnualized Compound Return for Next 1 YearAnnualized Compound Return for Next 3 YearsAnnualized Compound Return for Next 5 Years

Note: Unconditional annualized compound return for full sample is 9.27%

On average, independent of the magnitude of decline, the return of the S&P 500 over the periods referenced has been positive and greater than the long-term average of 10.02% in half of the time periods observed. Exhibits 2 and 3 provide information on developed international and emerging markets, which had similar results.

Exhibit 2: International Large Cap: January 2001-December 2015
Cutoff for DeclineFrequency of Such DeclinesAnnualized Compound Return for Next 1 YearAnnualized Compound Return for Next 3 YearsAnnualized Compound Return for Next 5 Years

Note: Unconditional annualized compound return for full sample is 3.43%

Exhibit 3: Emerging Markets: January 1999-December 2015
Cutoff for DeclineFrequency of Such DeclinesAnnualized Compound Return for Next 1 YearAnnualized Compound Return for Next 3 YearsAnnualized Compound Return for Next 5 Years

Note: Unconditional annualized compound return for full sample is 8.03%

Is the Recent Period Abnormally Volatile?

To answer this question, we must look at the S&P 500’s historical performance. From January 1926 to December 2015, the S&P 500 had a compound return of 10.02% and a standard deviation of 18.85. Over a more recent period, from January 2010 through December 2015, the S&P 500 had a return of 12.98% with a standard deviation of 13.09. Comparing these results with other historical periods, we can see that the recent period has not necessarily been more volatile. Exhibit 4 shows S&P 500 returns and standard deviation grouped by decade starting with January 1930; the data shows periods of higher and lower returns as well as periods of greater and lesser volatility.

Exhibit 4: S&P 500 Returns and Standard Deviation by Decade
 Return %Annualized Standard Deviation

During the so-called “Lost Decade” of January 2000 to December 2009, the S&P 500 Index had a compound return of −0.95% and an annualized standard deviation of 16.13.

Importance of Discipline

Once again, we must emphasize the importance of maintaining discipline in financial investing. In the midst of a market downturn, we may be inclined to look for some signal as to what the recent period means for future returns or to assume the current period is somehow different from what we have observed historically. Instead of jumping to conclusions or attempting to make predictions about what the future may hold, we find that thoughtful analysis of the available data can provide perspective. It is also important to remember that there is ample evidence to suggest that prices adjust in such a way that every day, there is a positive expected return on our invested capital. While the realized return over any period may be positive or negative, we expect that markets will go up.

As investors, we should remain disciplined through all periods in order to capture the expected returns the market offers. As always, we thank you for partnering with us.

Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. There is no guarantee an investing strategy will be successful.

All expressions of opinion are subject to change. This content is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

This article is based on research provided by Dimensional Fund Advisors (DFA) LP. DFA is an investment advisor registered with the Securities and Exchange Commission. True North Capital Alliance has no affiliation with DFA; however, the firm uses DFA funds and strategies in developing its investment models.

Trackback from your site.

Leave a comment

Quick Contact

Fill out my online form.

Latest Tweets

Advisory services are provided through True North Global Research, Inc., d/b/a True North Capital Alliance, a Minnesota Registered Investment Advisor, with notice filing in Texas

Copyright © 2015 True North Capital - Privacy Policy
Powered by Dala Ad Agency