It's That Time of Year

As is the case in most years at around this time, we’re facing another high volatility period in the markets. To be expected, there is good news and bad news about the current period.

The good news very simply is that this is an annual phenomenon and more or less transitory. For some reason, possibly behavioral, the markets swoon during September and October in most years. Some of the biggest historical drops in the market such as the crash that started the Great Depression, the crash of 1987, LTCM (Long-Term Capital Management), the Asian Currency Crisis, the start of the Great Recession, and more all occurred during the two months of September and October.

Some simple numbers help drive home the point. Over the last 100 years, the stock market has averaged about a 10% annual return. In dollar terms, $1 invested in the broad market 100 years ago would result in over $13,000 today. With such enormous returns, one would expect that the average returns invested in almost any part of the year would be significantly positive over the last 100 years. This is true with one exception: the two-month period of September and October. Over the last 100 years, money invested in this two-month period has had an average return of -0.8%. It is the only two-month period that is negative. A way to visualize how out of sync this is with the rest of the year is to note that if one had invested in the broad market every year on Sept. 1 and exited the market two months later on Oct. 31, and held cash for the rest of the months of the year, than $1 invested in the broad market 100 years ago would result in $0.45 today.

The good news is that the market crashes during these periods always end up reversing fairly soon afterwards. For example, following the Crash of ’87 (when on “Black Monday,” October 19, 1987, markets dropped over 20% in a single day), the markets rebounded and finished the year up (+2%) for all of 1987, and they were up over 12% in the following year. At the start of the Great Recession, the markets dropped over 10% in September 2008 (triggered by the Lehman Brothers bankruptcy) and close to 15% in October 2008. In 2009, the markets were up 20% for the year.

The lesson to take away from all of this is that an investor focused on long-term investing should just ignore the market volatility that results annually in September- October. An interesting thing to note is that many institutional money managers “close their books” on Sept. 1 (and some even go to all cash) and won’t touch them until Nov. 1. Due to capital gains taxation (especially the substantially higher rate on short-term capital gains), it’s not advisable for individual investors to go to all- cash during September-October. But the next best strategy is to not touch their portfolio during this time period (and in fact try to buy shares during this period).

The bad news about the current market volatility is that we can’t completely ignore the fundamentals of the macro-economy, which is partly driving the current volatility. The two biggest risk factors hitting the markets are inflation and supply chain cost increases due to higher international tariffs put in place. As an economy starts to perform better and better, prices throughout the economy start to increase. In the latest quarter, the US economy grew 3.5%, and 4.2% in the quarter before that. 4.2% was the fastest it has grown in several years, and the markets are now beginning to expect price increases, or inflation, to start hitting the economy. When the markets expect this, the first thing they do is drive up long-maturity interest rates. The interest rate on long-term Treasuries hit 3.4% recently; that is the highest it has been in several years. As long-term interest rates increase, those sectors of the economy that are sensitive to these rates start to cool off and even contract. For example, housing prices, which are tied to mortgage rates (which in turn are tied to long-term Treasury rates), have decreased for two months in a row. This cooling off spreads to other parts of the economy (a slowdown in housing would hit the construction and housing materials industries next), and the whole economy begins to cool down, or contract. This contraction then leads long-term interest rates to decrease, and the whole cycle repeats. This cyclicality is the nature of the modern global economy.

What is unusual right now is that the higher tariffs that have been put in place, and continue to be ratcheted up, are acting to increase inflation even further rather than allowing prices to decrease as would normally happen as sectors of the economy start to cool off due to higher interest rates. Simultaneously, the higher tariffs could slow down the strong economic activity faster than would normally happen with higher interest rates alone. That means the economy is facing the possibility of a combination of inflation and economic cooling off, aka, stagflation. Part of the reason the markets are so volatile is that they are starting to incorporate the possibility of such a scenario occurring for the global economy. Unlike the transitory volatility we discussed above, this is a scenario that will have long-lasting implications for the markets. The last time we experienced stagflation was in the 1970s, when stock markets were largely flat for a decade while interest rates were at record high levels simultaneously.

Sorting out how much of the volatility we are experiencing is of the transitory variety (the good news) vs how much is of the long-lasting variety (the bad news) is extremely difficult. The best we can do for the long-run is to have inflation protection and be well diversified across asset classes. But the question is always how much is enough, or possibly too much.