Introductions. The subject of today’s session, market volatility, is all too familiar to all of us. I’d be willing to bet that every person in this room has been stung to some degree by the market’s exceptional volatility in recent months. Since late 2007, many days have seen stock markets rise or fall over 5%, and many weeks have seen it flip-flop over 10%. While this may pose opportunities for traders, it gives the rest of us ulcers. What are individual investors supposed to do? Should you sell? Should you buy? Are there any rational investing strategies you can pursue in such an irrational environment? The purpose of this session is to help you answer these questions — to give you the knowledge and tools so you can more effectively cope with market volatility. We’ll begin by looking at today’s exceptional market environment, how it compares historically, and if it is indeed different this time around. We’ll then take some time to look at different metrics of volatility, and spend the bulk of the session reviewing five different strategies to more effectively manage your portfolio in volatile times. Lastly, I’ll share some perspectives on what lies ahead.
By any measure, the market environment since late 2007 has been exceptional. From its high of 1,565 in October 2007, the S&P 500 tumbled over 56%, bottoming out on March 9, 2009. Other major indexes had similar declines and most global benchmarks fared even worse. Valuations also tumbled, with the average P/E ratios for the S&P 500 falling from 19.7 to 14.1 at the market bottom. In 2008 alone, it is estimated that American families lost over $11 trillion in wealth. 1 It has indeed been a roller-coaster ride, albeit mostly down hill, as the series of events you see here each sent shocks throughout the financial system, causing stock markets to fluctuate wildly. Note the many sharp spikes in this chart — both downward and upward — illustrating this exceptionally high volatility. From 1950 to 2007, the S&P 500 rose or fell by more than 3% an average of two trading days per year. In 2008 alone, it recorded 42 days when it rose or fell by more than 3%. And in 2009, it recorded another 23 days rising or falling by 3% or more. 1 Source: Federal Reserve.
The events giving rise (or fall in this case) to the recent big bear are multitude. You’ve heard them all before, but it helps to consider them here — as continuum, with one leading to the next, and collectively, causing unprecedented volatility and a downward spiral in stock prices. [Read slide bullets.] This perfect storm of circumstances has led many to speculate that this time is different — that the fundamental investing strategies that have been used by investors for so long, no longer apply. But is this time really different?
Whenever anyone tells you that it’s different this time, be wary. Many of you may recall talk of a “new paradigm” back in 1999 or books about Dow 30,000. Likewise, we hear a lot today how doom is upon us and this time is different. Let’s take a look at some of the largest bear markets of the past 100 years and see how the current situation compares. Through March 9, 2009, the market, as measured by the S&P 500, tumbled almost 57% from its October 2007 high. This beats the mid-1970s drop of 48%, but falls short of the 1930s drop of 86%. We’ve also included Japan’s Lost Decade in here, since many fear that we may be falling into the same stagnant pattern. In terms of duration, the most recent bear apparently lasted 17 months, although by definition, we can’t say for sure that the bear ended until the market has hit a new high. This compares with 19 months for the mid-1970’s, 39 months for the 1930s, and 161 months (more than 12 years!) for Japan. It’s also useful to look at the economy during these periods. As you can see here, all four periods suffered economic stagnation or contraction, but these differed greatly in magnitude and duration.
Now let’s look at all of the most recent bear markets — all periods since 1950 where the market dropped 20% or more. Again using the S&P 500 as a gauge of the overall market, we see that there have been ten bears during this period. The average drop was 34%, and the average duration about 14 months.* Note the lighter blue bars on this chart. These represent the bull markets that followed each of the bears. The average bull market since 1950 lasted about 53 months and recorded a gain of 136%. But like the major bears of the past 100 years we saw in the last slide, these more recent bear markets have also varied in their magnitude and duration. This has to do with the specific circumstances surrounding and giving rise to each particular bear — not the least of which is the health of the economy. *Assumes recent bear market ended on 3/9/09.
So let’s consider how markets have fared during economic contractions. The red stripes on this chart indicate periods when the economy shrank — ten periods in all since 1950. Note that these ten periods seem to correspond closely to the ten bear markets we just saw. During these ten economic contractions, the stock market fell an average of 1.13%. This is because market cycles do not necessarily parallel economic cycles. In fact, stock market cycles generally lead economic cycles from 5 to 10 months. If we look at averages for the six months prior to the economic downturns, stocks have fallen on average of 0.35%.
So what conclusions can we draw from history? First, economic cycles don’t tell the whole story. Although almost every bear market has been accompanied by an economic contraction, the timing and magnitude of the two cycles varies considerably. Second, every bear is unique. As we’ve seen, bears vary in timing and degree, and each has it’s own historical context and causes. Yet at the same time, the recent bear may not be quite as different as many would have you believe. So far, it’s stayed within the limits of major bears experienced over the past 100 years. And, if history is any guide, the market will eventually produce new highs. What’s important to keep in mind is that the fundamental concepts and strategies of investing have not changed. Matching your portfolio composition to your risk profile is still critical. Diversifying your investments still reduces risk. And keeping a long-term perspective will still help you manage through volatile market conditions.
Now I’d like to spend a few moments talking about how stock market volatility is measured. There are two widely used gauges of volatility. The most common is standard deviation. Standard deviation measures the likelihood of an investment to yield above- or below-average returns over a period of time. For example, if a stock has an average annual total return of 10% and a standard deviation of 4.00, that means its performance is likely to vary from a low of 6% to a high of 14%. Standard deviation can also be applied to an index, such as the S&P 500, indicating how likely its returns are to vary from its average returns. Here we see that the 10-year standard deviation for the S&P 500 has averaged 14.91% over the past 50 years — not that different from where it’s been recently, although much higher than the boom times of the late 1990s.
The second major measure of market volatility is the VIX. It is used to measure the overall market’s volatility. “ VIX” is actually the ticker symbol for the Chicago Board Options Exchange Volatility Index. It is a weighted blend of prices for a range of options on the S&P 500 Index, and measures the market's expectation of volatility over the next 30 days. Although the VIX is often called the &quot;fear index,&quot; a high VIX is not necessarily bearish for stocks. Instead, the VIX is a measure of fear of volatility in either direction, including the upside. High VIX readings mean investors see significant risk that the market will move sharply up or down. Low readings indicate that investors perceive neither significant downside risk nor significant upside potential. This chart shows the VIX since its inception in 1990. As you can see, the index itself is highly volatile, but shows definite periods of relative calm (1992-1996 for example) and periods of turmoil — mid-2008 to mid-2009. Although many of you will not use such metrics of volatility, it helps to know at least what they represent, since analysts and fund managers use them regularly.
And now I’d like to shift gears and move on to the core part of today’s session: identifying specific strategies for investing in a volatile market. These strategies represent fundamental investing concepts that can be applied at any time. None of these should be new to you. But they are particularly important in a volatile environment, which is where their true value really comes forth. Let’s go over each of them.
When markets become volatile, the gut reaction for most of us is to panic. Most retail investors do exactly what they should not do: They buy when everyone else is buying — when prices are highest — and panic sell on the downside — when prices are depressed. So, lesson number one when investing in a volatile market is: Don’t panic. Don’t sell into a rapidly declining market and don’t buy into a rapidly rising market. You’ll just be following the herd and locking in losses. Panic selling also runs the risk of missing the market’s best-performing days. As this chart illustrates, missing just the 5 top-performing days of the 20 years ended December 31, 2009, would have cost you more than $16,000 based on an original investment of $10,000 in the S&P 500. Missing the top 20 days would have reduced your average annual return from 8.21% to 2.12%. You never know when the market is going to shoot up, so staying invested and not giving in to panic can really make a difference.
The second strategy that is especially critical in volatile markets is asset allocation. Asset allocation involves dividing your portfolio into different asset classes such as stocks, bonds, and cash, which each carry different levels of risk and return potential. During volatile times, more risky asset classes such as stocks tend to fluctuate more, while lower-risk assets such as bonds or cash tend to be more stable. By allocating your investments among these different asset classes, you can help smooth out the short-term ups and downs. In the example you see here, we have three different asset allocations: an all stock portfolio, a portfolio of 60% stocks, 30% bonds, and 10% cash; and a portfolio of 40% stocks, 40% bonds, and 20% cash. Note the total return and risk figures under each portfolio. As the chart above illustrates, over the long term (20 years), the more moderate 60% stock portfolio and 40% stock portfolio would have delivered similar returns to a portfolio dedicated 100% to stocks, but with much less risk.
In addition to diversifying your portfolio by asset class, you should also diversify it by sector, size, and style. Why? Because different sectors, sizes, and styles take turns outperforming one another. Different sectors tend to outperform or underperform in different phases of the business cycle. For instance, in the depths of a recession, defensive sectors such as Utilities and Consumer Staples often outperform. In the hight of a boom, Information Technology or Materials companies are more likely to outperform. Likewise, different size companies tend to outperform at different times. For instance, small-cap stocks tend to outperform large-caps at the start of the business cycle, while large caps generally outperform in the later stages. Similarly, different investing styles such as growth and value take turns outperforming one another, although these are less tied to the business cycle than sectors or market cap. By diversifying your holdings by sector, size, and style, you can potentially smooth out short-term performance fluctuations and lower the impact of shifting economic conditions on your portfolio.
But regardless of how well you diversify, you are still likely to see some fluctuation in your portfolio when a perfect storm of events such as we saw recently occurs. This is where the fourth key strategy comes in: Keep a long-term perspective. It is all too easy to get caught up in the stock market’s daily roller-coaster ride. How many of you keep tabs on the market daily? (show of hands) How many of you also do a mental calculation of it’s impact on your portfolio? (show of hands) This type of behavior is natural, but can easily lead to bad decisions. As this chart shows, the longer you hold an equity investment, the less likely you’ll experience high variability of returns. For all the one-year periods since 1926, returns have varied from as low as -67% to as high as 160%. Yet, for all ten-year periods, returns have not been below -4% or higher than 21%. And, note that for all periods of 15 years or longer, returns have all been positive. The lesson here is: Don’t get caught up in day-to-day or even week-to-week variations — in either direction. Instead, focus on whether your long-term performance objectives, i.e., your average returns over time, are meeting your goals.
The fifth key investing strategy is to consider buying opportunities. Although many of you may be rightfully gun shy in the wake of the market turmoil of recent months, one strategy you should seriously consider is selectively adding to your portfolio. This is especially true when prices are low versus historical averages. Stock relative valuations are measured by several different metrics. The most widely used is the price/earnings ratio — or the P/E ratio for short — which measures price as a ratio to earnings — typically trailing 12-month earnings. As you might expect, valuations tend to be higher in bull markets and lower in bear markets, as the “P” part of these ratios shrinks. But because company earnings also shrink when the economy cools, ratios don’t always contract as much as you think, and sometimes even rise. As we see here, the P/E ratio of S&P 500 stocks at the peak of the average bull market since 1950 was 30.0, and the average P/E at the bottom of a bear market during this period was 25.9. The average for all markets during that time was 17.8. In 2009, the P/E as of December 31 was 19.9, which was down from the November peak of 27.7. This was due mainly to expected increases in earnings in the fourth quarter. Of course, these represent overall market valuations. You’d want to consider the valuation metrics of specific investments as well as other factors before buying. A systematic purchasing plan, also known as dollar cost averaging, can help in volatile times, as it provides for regular purchases over a period of time, taking the guesswork out of specific timing of purchases.
Retirement plan participants warrant special considerations in volatile times. The five strategies I’ve just covered — Don’t Panic; Take Advantage of Asset Allocation; Diversify; Keep a Long-Term Perspective; and Consider Buying Opportunities — also apply to 401(k) or IRA accounts. But in volatile markets, plan participants are faced with the added challenge of maintaining their contributions. I’m sure many of you in this room have faced the ugly reality at one point over the past year of opening your plan statement only to find that your plan balance has shrunk — even after adding in your hard-earned contributions. Just think what you could have bought with that lost money. For many, such grim experiences have convinced them to reduce or even discontinue contributions to their plan. Wrong decision. Because qualified plans such as 401(k)s and 403(b)s are tax deferred, they save you money right out of the gate by allowing an immediate tax break on contributions. They also allow for tax-deferred compounding, which can make a significant difference over time. If you are confronted with a shrinking balance during volatile times, you’re much better off reallocating a portion of your plan investments to less volatile assets such as bond funds, “stable value” funds, or even money market funds, depending on what’s offered in your plan. If you are forced to cut plan contributions to make ends meet, remember to never cut contributions below your employer match. Employer contributions to your plan are in essence additional salary. By not contributing enough to get the full match, you would be turning away free money. Even if you are the victim of the troubling new trend of employers to cut their plan match, it’s still in your best interest to continue to contribute.
All of the strategies we’ve just covered are certainly applicable in the volatile environment we’ve all just lived through. But what about the future? Do they still hold if we enter a bull market or when markets calm down? The short answer to this is “yes.” But we should first consider what lies ahead. With the economy still sluggish and house prices not yet stabilized, plenty of challenges remain. There’s also the issue of bailing out banks and reigniting the flow of credit. But the new Administration and Congress, despite their battles, are committed to confronting the issues head on. They have already put through a number of measures such as the numerous bailouts, the establishment of TARP, and the big stimulus bill. And they have begun to tackle many of the underlying issues. Eventually, what will likely emerge is a financial system with increased regulation and oversight, as well as structural changes to the broader economy as businesses and consumers adapt to a changing dynamic. What all this implies for equity markets is that they are likely to remain volatile. In fact, given advancements in trading technology and the ever-increasing availability of information, volatility is likely to stay with us even when the financial system repairs and the economy improves.
With this in mind, I’d like to close by stressing the importance of looking ahead and not backwards. Remember that today’s market prices reflect tomorrow’s expectations, not yesterday’s. Clearly we’ve undergone a major financial crisis, but the market has come back a long way since its low in March 2009. And steps are being taken to put the economy and financial markets back on track. Markets will likely remain volatile. But in pursuing the time-proven strategies we h ave covered here today, you stand the best chance of meeting your long-term investment goals. And now I’d like to open the floor to questions.
AFN32287_1007 AFN32287_1009 Investing in a Volatile Market
AFN32287_1007 AFN32287_1009 Investing in a Volatile Market
Agenda <ul><li>Today’s market environment </li></ul><ul><li>Is this time different? </li></ul><ul><li>Learning from the past </li></ul><ul><li>Gauging volatility </li></ul><ul><li>Investing strategies in a volatile market </li></ul><ul><li>Looking ahead </li></ul>
Today’s Exceptional Market Environment Beginning of bear market Fed real effective rate below 0% Bear Stearns bailout announced National housing market down 20% from peak Barak Obama elected President U.S. economy enters recession Congress passes $787 billion stimulus package Federal Reserve takes over AIG Lehman Brothers files for bankruptcy Government takes over Fannie and Freddie U.S. Stock Market in Decline
Behind the Bear <ul><li>Bursting real estate bubble </li></ul><ul><li>Subprime crisis </li></ul><ul><li>Institutional bankruptcies and bailouts </li></ul><ul><li>Economic slump </li></ul><ul><li>Growing risk aversion of banks </li></ul><ul><li>Changing consumer attitudes </li></ul><ul><li>Changing demographics </li></ul>
Is This Time Different? Sources: Standard & Poor’s; Bureau of Economic Analysis; International Monetary Fund; Economic Planning Agency (Japan); National Bureau of Economic Research. GDP data is based on quarterly data for the most recent bear market and the 1970’s bear market; it is based on annual data otherwise. Periods of economic contraction do not exactly coincide with bear markets. *Assumes that the most recent bear market ended on March 9, 2009, and that the recession ended on March 31, 2009. Neither of these has been determined conclusively. Recent Bear * 1970’s Bear 1930’s Bear Japan's "Lost Decade" Drop in Market Value (peak to trough) 57% 48% 86% 80% Duration 17 months* 19 months 39 months 161 months Annualized Real GDP Growth -0.70% 1.5% -9.4% 1.5% Recession/Depression Duration 16 months* 16 months 43 months Over 12 years
Learning From the Past: Bear Markets Since 1950 Source: Standard & Poor’s. For the period from January 1, 1950, through December 31, 2009. Stocks are represented by the daily closing price of the Standard & Poor's 500. Past performance is not a guarantee of future results. (CS000144)
Learning From the Past: Stock Markets and Economic Contractions Source: Standard & Poor’s. For the period from January 1, 1950, through December 31, 2009. U.S. stocks are represented by Standard & Poor’s Composite Index of 500 Stocks, an unmanaged index that is generally considered representative of the U.S. stock market. Economic contractions are as defined by the National Bureau for Economic Research. (CS000228)
Learning From the Past: Conclusions <ul><li>Economic cycles don’t tell the whole story </li></ul><ul><li>Every bear is unique </li></ul><ul><li>Fundamental investing concepts and strategies still apply </li></ul>
Gauging Volatility: Standard Deviation S&P 500 Standard Deviation — 1959-2009 Source: Standard & Poor's. Represents the annualized monthly standard deviation of the total returns of the S&P 500 index for rolling 10-year periods from January 1959 to December 2009. Past performance is not a guarantee of future results.
Gauging Volatility: VIX Source: Chicago Board Options Exchange. For the period from January 1990 to December 2009.
Five Investing Strategies for a Volatile Market <ul><li>Don’t panic </li></ul><ul><li>Take advantage of asset allocation </li></ul><ul><li>Diversify by sector, size, and style </li></ul><ul><li>Keep a long-term perspective </li></ul><ul><li>Consider buying opportunities </li></ul>
Don’t Panic Source: Standard & Poor’s. This chart shows how a $10,000 investment would have been affected by missing the market's top-performing days over the 20-year period from January 1, 1990, to December 31, 2009. Stocks are represented by Standard & Poor's Composite Index of 500 Stocks, an unmanaged index that is generally considered representative of the U.S. stock market. Past performance is not a guarantee of future results. (CS000076)
Take Advantage of Asset Allocation All Stock Portfolio 40% Stock Portfolio 60% Stock Portfolio *Annualized monthly standard deviation. Sources: Standard & Poor’s, Barclays Capital. For the periods ended December 31, 2009. Stocks represented by the S&P 500 index. Bonds represented by the Barclays U.S. Aggregate Bond Index. Cash represented by the Barclays 3-Month Treasury-Bill Index. Past performance is no guarantee of future performance. Total Return Risk* Total Return Risk* Total Return Risk* 1-year 26.45% 21.36% 17.77% 14.03% 13.06% 9.82% 5-year 0.41% 16.04% 2.34% 9.96% 3.07% 6.94% 10-year -0.95% 16.13% 1.93% 9.73% 3.06% 6.61% 20-year 8.21% 15.03% 7.72% 9.31% 7.19% 6.49%
Diversify by Sector, Size, and Style <ul><li>Sector outperformance varies with the economic cycle </li></ul>Source: Standard & Poor’s. Sector performance represented by the performance of the 10 GICS sectors within Standard & Poor's Composite Index of 500 Stocks. Past performance is not a guarantee of future results. (CS000172) Sector Rotation -- 2000 to 2009 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Utilities 57.17% Materials 3.50% Consumer Staples -4.28% Information Technology 47.23% Energy 31.54% Energy 31.37% Telecom Services 36.81% Energy 34.41% Consumer Staples -15.44% Information Technology 61.71% Health Care 37.06% Consumer Discretionary 2.79% Materials -5.46% Materials 38.23% Utilities 24.33% Utilities 16.84% Energy 24.20% Materials 22.55% Health Care -22.81% Materials 48.58% Financials 25.69% Industrials -5.75% Energy -11.13% Consumer Discretionary 37.42% Telecom Services 19.85% Health Care 6.48% Utilities 20.99% Utilities 19.39% Utilities -28.97% Consumer Discretionary 41.30% Consumer Staples 16.78% Consumer Staples -6.41% Financials -14.64% Industrials 32.20% Industrials 18.05% Financials 6.48% Financials 19.18% Information Technology 16.33% Telecom Services -30.49% Industrials 20.91% Energy 15.68% Financials -8.95% Health Care -18.84% Financials 31.13% Consumer Discretionary 13.26% Materials 4.43% Consumer Discretionary 18.67% Consumer Staples 14.18% Consumer Discretionary -33.48% Health Care 19.70% Industrials 5.88% Energy -10.41% Consumer Discretionary -23.81% Utilities 26.36% Materials 13.21% Consumer Staples 3.59% Materials 18.64% Industrials 12.01% Energy -34.88% Financials 17.20% Materials -15.72% Health Care -11.94% Industrials -26.34% Energy 25.61% Financials 10.90% Industrials 2.32% Consumer Staples 14.37% Telecom Services 11.95% Industrials -39.91% Consumer Staples 14.89% Consumer Discretionary -20.00% Telecom Services -12.26% Utilities -29.99% Health Care 15.04% Consumer Staples 8.18% Information Technology 1.00% Industrials 13.29% Health Care 7.16% Information Technology -43.14% Energy 13.82% Telecom Services -38.81% Information Technology -25.87% Telecom Services -34.11% Consumer Staples 11.58% Information Technology 2.56% Telecom Services -5.62% Information Technology 8.40% Consumer Discretionary -13.21% Materials -45.64% Utilities 11.91% Information Technology -40.89% Utilities -30.44% Information Technology -37.42% Telecom Services 7.09% Health Care 1.77% Consumer Discretionary -6.36% Health Care 7.53% Financials -18.64% Financials -55.32% Telecom Services 8.93% S&P 500 -9.09% -11.88% -22.10% 28.69% 10.87% 4.89% 15.79% 5.50% -36.99% 26.45% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Keep a Long-Term Perspective <ul><li>The longer the holding period, the lower the variability in returns </li></ul>Source: Standard & Poor’s. For all indicated holding periods between between January 1, 1926, and December 31, 2009. Domestic stocks are represented by the total annual returns of Standard & Poor's Composite Index of 500 Stocks, an unmanaged index that is generally considered representative of the U.S. stock market. Past performance is not a guarantee of future results. (CS000070)
Consider Buying Opportunities Market Valuation Metrics in Selected Bull and Bear Markets Source: Standard & Poor’s. For the period from January 1, 1950, through December 31, 2009. Price/earnings ratios are based on 4-quarter trailing earnings. Average bull and bear market peak and bottom ratios based on final month average in cycle. Price/Earnings Ratio 2000-02 bull market peak (2000) 30.0 2000-02 bear market bottom (2002) 25.9 2007 bull market peak (2007) 19.9 Average bull market peak since 1950 19.6 Average bear market bottom since 1950 16.9 Average all markets since 1950 17.8
Special Considerations for Retirement Plan Assets <ul><li>Reallocate, don’t cut </li></ul><ul><li>Never cut contributions below employer match </li></ul><ul><li>If employer cuts match, contributing still makes sense </li></ul>
Looking Ahead <ul><li>Economy still in a downturn </li></ul><ul><li>Housing slump continues </li></ul><ul><li>Administration and Congress are confronting the issues </li></ul><ul><li>Increased government oversight of financial markets will come </li></ul><ul><li>Other structural changes to markets and economy are likely </li></ul><ul><li>= Market volatility is likely to remain a given </li></ul>
Forward, Not Back <ul><li>Steps to recovery in process </li></ul><ul><li>Upside greater than downside </li></ul><ul><li>Using time-proven investing strategies is the best way to deal with continued market volatility </li></ul>
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