This Picture Really is Worth 1,000 Words...

The chart below is really big... and also a bit complicated.  But bear with me, it’s worth going through.  Sometimes a picture is worth a thousand words. The black bars in this chart from JP Morgan show the price return of the S&P 500 for every year since 1980. The red dots show the largest drop from peak to trough during each year. While it is easy to forget during periods of market turmoil, notice that stocks gained ground in all but 8 of the past 35 years. But this doesn’t mean the going was easy. During each of the 35 years, stocks experienced a pullback. These declines averaged 14% but some of them were quite substantial. In 6 of the years, the intra-year declines were greater than 20%. The take-away? Stock investing is not a one way street. Volatility is a fact of life.

Investors today are wondering whether the latest August pullback was the start of another major market decline. As evidence of this possibility, many market pundits point to the fact that we have gone over six years without a major retreat in stock prices and to stocks’ somewhat elevated valuation levels today. While we cannot know for certain, I think the odds are against a major decline. Since 1926, stocks have fallen into bear market territory (declines of 20% or more) ten times. While the circumstances leading up to these declines varied, all but two were accompanied by a recession here in the U.S. Other factors that contributed to the downturns include commodity price spikes, aggressive tightening by the Federal Reserve and excessive stock price valuations.

None of these conditions appear present today. It is true that growth outside the U.S. is tepid at best, but the U.S. economy seems to be in fairly good condition. The job and housing markets are advancing nicely as are retail sales. Commodities are anything but elevated with oil, agricultural and metals prices now near multi-year lows. Finally, while the Federal Reserve appears about ready to inch rates up, the expected increases can hardly be described as “aggressive.” The issue of stock price valuations perhaps poses the greatest risk but even here I think the evidence is mixed. While valuation measures such as price-to-earnings and price-to-book value ratios are indeed above long-term historic averages, they may well be justified given today’s historically low level of interest rates and inflation.

Owning stocks can be an unsettling experience for many investors. If the latest market turmoil has you losing sleep, then it may be a signal that you need to re-evaluate your strategy. But before you make major changes, recognize that in the short-term investor emotions, not economic fundamentals drive stock price behavior. If you are careful to purchase shares at reasonable valuations and hold for the long term, then you should be fine.