Benjamin Graham, the well-known value investor, in The Intelligent Investor created Mr. Market as an analogy to describe how the stock market works. “Every day he tells you what he thinks your interest [in your business partnership with him] is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible… Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you little short of silly.” Given this appraisal, it might seem absurd to try to draw lessons from financial markets’ behavior in 2016. However, a look back at the year provides some insight.
First, consider the first six weeks of 2016. Through 2015, Mr. Market had been characterized mainly by growth off the lows of 2009 (at least here in the U.S.). But last year started with a stock market decline of 10.5% in the S&P 500 by February, as shown below.
Many investors worried that this volatility marked a return to the Great Recession. They considered shifting assets from stocks to cash and/or bonds. Such a move would provide protection against further stock downturns, but would also provide “protection” against stock upturns.
As it happened, the S&P 500 finished the year with gains over 11%, and investors who were patient through the pullback were able to capture this growth. In other words, market participants who did not allow short-term movements to affect their decisions were rewarded. To put that in context, here’s what S&P 500 performance looked like for the full year.
Data from Macrotrends.net
At Dowling & Yahnke we take advantage of market pullbacks in a number of ways. We rebalance portfolios when warranted to maintain the target allocation outlined in each client’s written investment policy. We also harvest tax losses to offset capital gains which might otherwise be generated in the rebalancing process. In addition, we invest any idle cash at the lower prices available during a market drop.
No one can accurately forecast market movements in the short run. Even though guesses may be based on observable markers such as political polls, they can still be wrong. For this reason, attempting to time the stock market doesn’t work. The first object lesson in 2016 was the Brexit vote on June 23rd (which also served as a reminder that world events affect U.S. markets too.) Most polls predicted that Britons would narrowly vote to stay in the European Union, but the actual result was a narrow vote to leave the E.U. As a result, stock market indices fell, including a 3.6% drop in the S&P 500 and 3.2% drop in the leading British stock index, the FTSE. As the value of the British pound plummeted in the immediate aftermath of the vote, there were fears of a liquidity crisis. However, within a few days the markets rallied returning to pre-vote levels in a couple weeks. The same pattern repeated itself with the U.S. presidential election. Most polls predicted a victory by Hillary Clinton and futures markets fell sharply overnight in the hours following Donald Trump’s win. Nonetheless, U.S. markets rallied once they opened the next morning. Patient investors, who did not attempt to trade on short-term political news, captured the rebound without incurring any trading costs, and were rewarded for maintaining focus on their long-term goals.
The swings experienced in 2016 illustrated once again the futility of trying to time the stock market. Last January few would have predicted that Mr. Market would return almost 12% for 2016, with over 11% appreciation in large stocks and over 21% in small. Or that value stocks in developed foreign markets would increase over 7% (with all foreign stocks up 4.5%). Bonds also finished in positive territory last year with an increase of 2%. Rather than try to guess which asset class to get in or out of and when, investors would be better off selecting an appropriate target asset allocation which fits their long-term goals and risk tolerance and rebalancing to that target in a disciplined fashion. By following the principles of diversification and risk-appropriate allocation, with regular rebalancing, market participants are more likely to meet with long-term success.