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In the bull market of the last few years, we have seen diversification drag portfolio returns more than enhance them, particularly if you only held the S&P 500. In recent history, in 2022, when the stock market was trading lower, the bond market was selling off significantly as well as interest rates were quickly climbing. Nonetheless, while bonds didn’t prevent losses in 2022, they did help mitigate them, albeit not as much as prior downturns since both bond and stocks sustained double-digit losses.
Last week, in the face of unexpectedly large tariff amounts, equity markets sold off significantly and continue to experience large intraday movements. In contrast to 2022, this time, bonds acted more like bonds, offering a backstop and rallied higher. Volatility levels have spiked to much higher levels. We are currently in a fairly extreme “risk off” environment.
While tariffs are being cited for the cause of the equity market downturn, we would argue that there is a reasonable argument to be made that we would have gotten here at some point regardless of circumstance. As Syl pointed out in his market outlook piece earlier this year when speaking about Warren Buffett’s markedly increased cash position at Berkshire Hathaway:
“Perhaps, the simplest explanation for Warren’s current cash binge is that stocks are simply too expensive, that the cost of entry into this new AI world is simply too high, skewing the risk/return dynamics unfavorably. One example of today’s exorbitant prices is found in one of Warren’s favorite valuation metrics: the ratio of stock price relative to the size of the U.S. Gross Domestic Product. By that measure, stocks are grossly overvalued, more so than even in the late 90’s bubble.”
As it stands right now, valuations in large companies have come down significantly from the peak and in our view are now approaching their fair market value. There is an argument to be made that smallcaps are already undervalued. That being said, the old adage remains, “markets can remain irrational a lot longer than you and I can remain solvent”. There is no question that uncertainty in policy with potential trade wars is a recipe for heightened volatility. The stock market rarely rallies in the face of uncertainty. And this is precisely why we diversify, and precisely why we look at markets from a long-term view.
When in doubt, zoom out.
S&P 500 Recent Performance
This is a chart for the S&P 500 over the last five years. These returns are phenomenal, even after accounting for the last few weeks.
Events Impacting the Stock Market in the Last 20 Years
Keep in mind that over the last 20 years, we also had a few events that also had impacts on the stock market:
So how did I personally handle the drawdown in stocks with my own money?
I bought stocks. And then I bought more of them the next day. And if it goes down more, I will plan to buy more.
We will be doing the same thing in our client portfolios: diversification works best with systematic rebalancing, which we also practice. Just like diversification has looked bad in the last two years’ bull market, so has rebalancing, but it has helped ensure that our clients have maintained their proper risk profile. Now, as the stock market goes down, we will be working to rebalance portfolios to the appropriate risk levels and buy stocks while they are down. Should you want more data on rebalancing and its benefits, here is a research paper in the Journal of Financial Planning.
You hire us to objectively look at markets, keep a long-term view, and appropriately diversify our client assets to match with their risk levels. No matter the environment, we will always keep these principles.
We are always here to discuss how this is impacting your situation personally, so please feel free to reach out to us and schedule a call.
