5 Key Investing Truths For 2019

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based TOPS ETF Portfolios.

Investment markets finished 2018 on a sour note, with the S&P 500 dropping 10% in the last four weeks of the year. Many investors are struggling to remember the last time investment markets delivered a negative calendar-year return, as U.S. stocks have been riding a bull market for almost a decade.

The prolonged bull market in U.S. stocks and the extremely low volatility of 2017 have made 2018 feel like a splash of cold water.

It is important for investors to note, however, that 2018 was more “normal” than 2017.

Investment markets, and the underlying economies, are expected to experience natural cycles over time. Trees don’t grow to the sky and asset prices typically don’t go to zero. While our minds tend to recognize trends and expect them to continue indefinitely, the natural oscillations of investment markets are the norm rather than the exception.

Risk aversion is an essential part of investing. Investors by nature are risk-averse, and the collective risk aversion of investors is what makes markets function.

However, it is risk aversion that makes us dislike experiencing the expected downward slope of the cycle, even though rational investors understand markets that benefited from abnormal appreciation are more likely to experience a cyclical correction than to continue growing toward the sky.

It has been said that investing is simple, but not easy. This is especially true for risk-averse investors. Hopefully, the following five key thoughts will be helpful to investors as we start 2019, and serve as a useful tool to make sense of current markets.

1. Most equity investments were in the red in 2018

Investment results for 2018 will be confusing for some investors. While the S&P 500 was down for the year about -4.4%, it was still one of the best-performing global indexes for the year. Therefore, most diversified portfolios underperformed the S&P 500 in 2018.

Source: Bloomberg. As-of 12/31/2018

High-quality fixed income has rallied as the market correction has intensified, which has provided diversification for balanced accounts.

Source: Bloomberg. As-of 12/31/2018

2. Market drawdowns are normal

Since volatility has been tepid for so long, some investors may perceive market movements in 2018 to be extreme. However, the drawdown we experienced at the end of the year is quite normal. Actually, 2017 was the extreme year.

• Maximum drawdown YTD 2018: -20%
• Maximum drawdown 2017: -3%
• Average maximum drawdown since 1928: -16%
• Median maximum drawdown since 1928: -13%

This year, investors should have some deja vu. According to Charles Schwab, the average S&P 500 drawdown in a midterm election year is -16.0%. The average 12-month gain from that trough has been +32.0%. We are now down 14.3% from the Sept. 21 high.

3. Recessions are to be expected

With the end-of-year market decline, investors have been turning more attention to the prospect of a recession on the horizon for the U.S. Recessions are defined as a fall in gross domestic product for two-consecutive quarters.

It has proven very difficult historically to predict the exact time period in which a recession will occur. Trying to time in and out of the market to avoid potential recessionary stock pullbacks has proven to be very difficult as well.

Recessions are a normal part of economic cycles. While bear markets in stocks occur more frequently, there have been eight recessions since 1960. Recessions have lasted one year on average. Over the nearly 60-year period, the economy was in recession 13% of the time. Likewise, we have had at least one recession every decade for the last five decades.

There has been a lot of discussion throughout the year about the risk of an imminent recession. Of note, many market pundits have talked about the risk of an inverted yield curve leading to a recession.

An inverted yield curve means the yield on 10-year U.S. Treasury bonds is lower than the yield on the two- year U.S. Treasury bonds. While the yield curve did not invert in 2018, it got very close, with the difference in yield hitting a low of 0.11%.

Historically, inverted yield curves have predated each U.S. recession. The problem is, the average time period between an inverted yield curve and a recession is 18 months, with a pretty wide dispersion.

Likewise, the normal frequency of recessions historically would make it likely that a recession follows nearly every event within a few years. Inverted yield curves are something to monitor. However, we do not advocate trying to time in and out of the market to avoid recessions. Instead, we support maintaining a disciplined strategic investment strategy.

Recessions Since 1960

Source: NBER

4. Investment cycles are normal

We have experienced a prolonged market cycle recently, where large-cap growth stocks have been a top performer. Without caution, investors may succumb to recency bias given the recent cycle.

Simply put, recency bias can be defined as most easily remembering something that has happened recently, compared with remembering something that may have occurred a while back.

Recency bias can lead investors to question fundamental investment disciplines, such as diversification. Instead of remaining disciplined, temptation may rise to concentrate allocations toward investments that have recently outperformed.

It is absolutely normal to experience multiyear cycles where certain asset classes outperform consistently, only to reverse course in the following cycle. Two areas that are good examples are growth versus value stocks, and U.S. versus international stocks.

Source: Bloomberg

5. Valuations are historically strong predictors of long-term investment opportunity

Leading into the most recent correction, we wrote extensively about the relatively high valuations of U.S. stocks. Now, recent pull backs have reduced those valuations, increasing expected returns. Further, previously attractive valuations for International stocks have now become even more attractive, from a fundamental standpoint.

As Howard Marks said in “Mastering the Market Cycle”: “Ceterus paribus, or all things being equal, the outlook for returns will be better when investors are depressed and fearful (and thus allow asset prices to fall) and worse when they’re euphoric and greedy (and drive prices upward).”

Over time, economies tend to grow, company profits tend to increase and markets tend to rise. We expect global economies and markets to grow in the coming decades. As such, current investors should be more optimistic toward long-term expected returns after market drawdowns, rather than after market appreciation.

This means stocks may look more attractive now for long-term investors than they did in September 2018. As such, current investors should be more optimistic toward long-term expected returns than they likely were in September 2018.

Trailing 12-Month PE

Source: Bloomberg. As-of 12/31/2018

Focus On Financial Goals

Often, investment portfolios are the focus of an investor’s financial picture. While investment portfolios are an integral part of the overall financial picture, we encourage investors to keep their focus on long-term financial goals. Investment portfolios are a sophisticated tool designed to help investors reach their financial goals, not a bank account for short-term cash needs.

Volatility is expected in investment portfolios and necessary to allow for long-term investment appreciation. As discussed, investors are risk-averse in nature, meaning they don’t like to see portfolio values fluctuate. However, it is a normal part of the investment process.

ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.