Back Where We Started Again

May 2016

When the markets are going up, it’s easy to believe the good times will never end. It would be great if the markets were always steady, or better yet, were always on an upward trend. However, the fact is that market cyclicality, with both up and down markets, are a normal part of market activity. Bear markets, defined as a drop of 20% in equities, have historically occurred on average about every two and a half years for the S&P 500. By this measure, it can be argued that the markets are overdue for a significant correction.

The rewards of bull markets, however, have historically overridden the negative effects of bear markets, and over the long term stocks have historically produced real positive returns above other asset classes and well above inflation.

A rocky start to the year

The past nine months have underscored the fact that markets can move significantly. In the last half of August 2015, the S&P 500 declined by over 10%. After regaining most of the losses by the end of the year, January proved to be volatile, with declines of more than 11% between January 1, 2016 and February 11, 2016.

The August 2015 and January2016 market declines were driven primary by global concerns.

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Since the February 11th low, the U.S. markets have recovered most of their losses, although the market did drop in the last half of April and beginning of May amid renewed global concerns as well as somewhat lackluster U.S. economic growth data. Global markets also rebounded since the mid-February inflection point, only to drop in the last couple of weeks of April and beginning of May.

Central bank activity promotes positive market direction

We believe several factors contributed to positive market movement:

  • The expectation that the European Central Bank (ECB) and the Bank of Japan (BOJ) would continue quantitative easing and would maintain low to negative interest rates in Europe and Japan hopefully encouraging increased lending and liquidity in order to stimulate their economies

  • Indications by the U.S. Federal Reserve (Fed) that additional hikes in interest rates in 2016 will likely take place on a decelerated timeframe versus previous expectations given current global economic circumstances and election year considerations to help preserve the path of U.S. economic growth

  • The upward movement in oil prices from a low of just under $30 per barrel in February to current prices in May above $40 a barrel. Recently, the correlation between the direction of oil prices and the S&P 500 has increased dramatically, up to 0.70 in the past year according to Strategas Research, versus -0.10 correlation over the past ten years. As a result, rising oil prices over the last few months have been matched by market gains

Uncertain markets are likely ahead

Despite progress, many global and domestic economic, political and market issues still remain as is evident from continued up and down markets.  It is our view that continued wide market movements are likely to continue throughout the year.  However, we do feel that S&P 500 stocks are fairly valued at the current level.  As a result, based on current earnings growth estimates for 2016, stock prices should be sustainable, in our view.

Staying the course in the face of volatility

While it is easy to see the value of equity investing in the long term, it can be tempting to react emotionally to extreme market conditions.  We believe there are some actions investors can take to help stay the course:

Actions to Stay the Course

  • Asset allocation, even simply diversifying into stocks and bonds, can help substantially. Since 1926, stocks and bonds have had negative returns in the same year only 2% of the time. Going through the exercise of asset allocation is useful in mitigating emotional decision-making by helping investors develop a portfolio that is appropriate for their objectives, time horizon and risk profile. Diversification is one of PNCs core investment tenants

  • Asset classes or strategies that complement a traditional portfolio, such as smart beta, which can concentrate on exposure to factors, including low volatility, dividend growth and quality, that are less volatile, may help reduce overall portfolio volatility

  • Allocating a portion of one’s portfolio to a non-traditional asset class, such as alternatives for qualified investors, can help provide protection against downturns in the market or opportunities to enhance returns because they have lower correlations to stocks and bonds, meaning they tend to react differently to varying market conditions. Adding alternatives that perform differently than traditional asset classes and each other can help increase risk-adjusted returns. Since different types of alternatives tend to have lower correlations to each other, this can likely further increase portfolio diversification

  • Rebalancing goes hand in hand with proper asset allocation. As each asset class performs differently over time, allocations will drift, and investors may find themselves greatly over or under represented in asset classes. Rebalancing brings the asset allocation back in line with an investor’s goals and risk appetite. It also has the positive result of buying at lower prices and selling at higher prices. Research based on past data has shown that rebalancing, especially with an allocation to alternatives (for qualified investors), historically produces results that are superior to a buy and hold strategy

Rebalancing with Alternatives*

(*Alternatives are for qualified investors)

Backtest from 1990 through May 2015

Market Correction Negative Periods Average Drawdown Highest Return Lowest Return Maximum Drawdown Return Annualized Sharpe Ratio Standard Deviation
Not Rebalanced 99 -5.54% 6.55% -10.86% -31.80% 8.90% 0.68 8.70%
3-Month Rebalanced 101 -5.32 6.62 -11.12 -31.92 8.85 0.69 8.51
6-Month Rebalanced 101 -5.32 6.61 10.79 -31.46 8.79 0.68 8.44
Annually Rebalanced 101 -5.28 6.72 -10.35 -30.82 8.93 0.70 8.41
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In short, while it is likely that volatility will continue in 2016, taking strategic action can help to reduce volatility and improve the ability to maintain one’s plan.

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Important Legal Disclosures and Information

  1. Source: PNC

  2. Source: Ibbotson Associates, Morningstar, PNC

The material presented in this article is of a general nature and does not constitute the provision by PNC of investment, legal, tax, or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at 1-888-762-6226.

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