The current volatility in financial markets is again reviving unwelcome feelings among many investors — feelings of anxiety, fear and a sense of powerlessness are taking hold as developments in Europe unfold and investors try to navigate their way through the “new normal.” These are completely natural responses. Acting on these emotions and perceptions, though, can end up doing us more harm than good.
The concept of a “new normal” is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.
The increase in market volatility is an expression of uncertainty. The government debt strains in the U.S. and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to sell risky assets. A vicious feedback loop between growth, government debt concerns and banking woes is now in motion. For example, Standard & Poor’s recently cited weakening growth prospects as an important factor in lowering Italy’s credit rating. In conjunction with the downgrade, yields rose, and Italy will now pay more on its borrowings, making it even harder to achieve its fiscal targets. In an effort to bring balance to its budget, it will need to cut spending, thus lowering future expectations of growth.
It is reminiscent of the events of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets. As outlined in our July 2011 Commentary, while deficits and debt levels may impact a nation’s interest rates and economic growth, the investment implications are not easily discerned. History does not offer strong evidence that these factors predict future bond or equity returns in a country’s financial markets.
There are a few points investors can keep in mind to make living with this volatility more bearable:
- Markets are unpredictable and do not always react the way the experts predict they will. As pointed out in our August 8, 2011 Commentary, the downgrade by Standard & Poor’s of the U.S. government’s credit rating immediately preceded a strengthening in Treasury bonds.
- Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009 — when market sentiment was last this bad — the S&P 500 turned and logged seven consecutive months of gains totaling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
- Provided U.S. and global economies continue to grow, even slowly, stock valuations remain very attractive relative to bonds.
As to what happens next, no one knows for sure — which brings the concept of “normal” into question. What exactly is the status quo in the markets? Annual returns are rarely in line with the market’s 9.7% long-term average (annualized). The most obvious “normal” may be that, over time, stock returns compensate investors willing to bear market risk in periods of high uncertainty.