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Date: November 26, 2018
Category: Alternative Investments

Making Sense of the “Jinx” Month’s Market Volatility

In the equity markets, it’s best not to hang your portfolio on the uncommon. Markets are cyclical, and history typically repeats itself. So, while 2017’s uncommon calm in equities was welcomed relief for both your portfolio and your blood pressure, you had to know it wouldn’t last forever. As the typical is back to being more predictable, how can you develop strategies to help handle market volatility?

Volatility returned in February, writing about it here, as interest rates and increased trade tensions overwhelmed a skittish market. Now, with both still deeply embedded in the market’s ups and downs, several new geopolitical tensions have latched on to the laundry list of worries.

Historically known as the “jinx month” for its volatility (history does repeat itself), October experienced huge selloffs just like in 1929 and 1987. In fact, the worst month of the financial crisis was October 2008, when stocks gave up close to 17 percent.1 The S&P, Dow Jones, and small-cap Russell 2000 Index all erased most of their 2018 gains, while the tech-focused NASDAQ fell into correction territory.

Investors are nervous about rising interest rates – even as the Federal Reserve has been rather transparent on its plan to normalize monetary policy. Trade disputes, especially an escalating tit-for-tat with China, will remain at the forefront if talks at the Group of 20 summit in Buenos Aires fail to produce an agreement. In fact, some reports indicate that the U.S. is ready to place tariffs on all remaining Chinese imports if talks collapse.2

Also, recent U.S.-Saudi tensions, the Brexit stalemate, and the fall-out over the midterm elections are all weighing on investors’ conscience. The CBOE Volatility Index, or VIX, had its biggest one-day surge since February in early October. Outside of February and March, the “fear gauge” hit levels not seen since the summer of 2016.3

One thought is that October’s outflows were in part a by-product of passive investing. Over the past decade, billions have poured into ETFs and other products. ETF assets recently hit $5 trillion globally, up from $800 billion in 2008.4 Typically, ETFs trigger forced selling as volatility goes up. Along with emotional and event-driven sell-off, this “programmatic trading” likely contributed to the spike in volatility.

Do you remember the flash crash of 2010? Of the securities that dropped 60 percent or more on that day in May 2010, approximately 70 percent were ETFs. And that was when passive investing was roughly 30 percent of assets under management – not the 80-to-90 percent it is today.5 Keep that thought in mind when you read headlines like this October 11, 2018 splash from Bloomberg: “Sell Orders in Stocks Surge to Highest Level Since ‘Flash Crash.’”6

October saw stocks and bonds both take a relative dive – just another illustration that there’s a growing correlation between these traditional asset classes.

Yet, there’s something about today’s volatility that signals a new normal. Savvy investors and financial professionals have always echoed that volatility brings some of the best buying opportunities due to market mispricing. Buying the S&P 500 after a week of negative returns was profitable from 2005 through 2017. However, buying the dip has not been a prudent play in 2018, with an average loss of roughly five basis points.5

So, if buying the market during volatility isn’t working out, and bonds are experiencing their own volatility along with interest rate headwinds, what’s the best approach to avoiding panic (and reading these articles) every few months? Diversification.

Strategies to help handle market volatility

Diversification is about finding the right balance of assets that don’t move in unison. Decreasing your portfolio’s correlation, at a time when stocks and bonds are more correlated, requires untraditional thinking. Commercial real estate and corporate credit both have a lower correlation to traditional asset classes. Private real estate falls outside the whims of public markets, and senior secured loans historically generate positive returns as rates rise, while traditional bonds tend to lose value.

Within fixed income, it may be best to shorten your portfolio’s duration or its sensitivity to changes in interest rates. The Barclays U.S. Aggregate Total Return Value Index, a benchmark for many fixed-income allocations, has become more sensitive to interest rates over the last decade, with its duration climbing from 4.31 years to 6.03 years.7 Senior secured loans, meanwhile, have a duration of 0.25 years since they typically reset to their benchmark every 90 days. A shorter duration gives investors more flexibility and may minimize the pain of interest-rate-induced volatility.

Structural diversification may also support a long-term strategy. Illiquid investments like private equity and hedge funds, non-traded REITs, and interval funds may help negate emotional selling. You can’t immediately access your capital with these investments, which may not be a bad thing if you are an emotional investor trying to invest for the long haul. If you’re unable to tolerate a completely illiquid option, consider that interval funds offer a level of liquidity through a feature that typically allows redemptions every 90 days.

Finally, you may want to dig deeper into the differences between equity and credit investments. We are late in the current cycle, so while equity investments seek higher returns, they also carry more risk. After a historically long bull market, going long equity may not work if you’re sensitive to market risk. Credit investments may help insulate a portfolio from loss, cushioning the downside risk during periods of dislocation. These investments pay either a fixed- or floating-rate coupon with the goal of returning your principal at maturity.

Predictable volatility does not mean predictable strategies

As history repeats itself, that doesn’t mean your portfolio strategies have to follow the same course. While the 60/40 portfolio benefitted investors during the recent high-growth, low-interest-rate environment, we’re now in a rising-rate, late-cycle environment. That historically means the return of volatility.

You can curb your reactions to these market moments by building a portfolio that makes them just part of the process. Look at diversifying your portfolio with different asset classes and structures that fit your needs, while exploring equity and credit investments built for the environment you’re investing in.

1 USA Today. Dow, hit by October blues, posts loss after Caterpillar, EM offer worrisome forecasts. 10/23/18.

2 Bloomberg. U.S. Plans More China Tariffs If Trump-Xi Meeting Fails, Sources Say. 10/29/18.

3 Bloomberg. CBOE Volatility Index. 10/30/18.

4 NASDAQ. Assets Invested in ETFs/ ETPs Globally Broke $5 Trillion Milestone. 2/9/18.

5 Forbes. Take Advantage of Volatility with Active Management. 10/29/18.

6 Bloomberg. Sell Orders in Stocks Surge to Highest Level Since ‘Flash Crash’. 10/11/18.

7 Bloomberg. Barclays U.S. Aggregate Total Return Value Index Option Adjusted Duration. 6/30/09-6/30/18.

Resource Securities LLC, Member FINRA/SIPC.

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