Recent volatility offered a reminder of five key lessons

Review the latest Weekly Headings by CIO Larry Adam.

Key Takeaways

• Market narratives can change quickly
• Volatility is part of the fabric of the market
• Avoid panic selling during volatile periods

What a week it’s been. Market gyrations have captured investors’ attention over the last week as many asset classes (bonds, stocks, foreign exchange markets) experienced sharp price swings. While we have been warning that the equity market was vulnerable to a pullback as rising macro, micro, and political uncertainties posed a risk, the velocity of the recent market moves (not just here in the U.S., but globally) has been unsettling. During these volatile times, it is important to maintain perspective, stay focused on your long-term objectives, and avoid knee-jerk reactions based on the latest twists and turns in the market. While sentiment shifts can move markets in the short term, fundamentals matter more for the direction of the market in the long run. Here are five key lessons we were reminded of this week:

1. Narratives can change quickly | While minor cracks in the economy have been building, growth has thus far remained resilient. That is why the market, until recently, had overwhelmingly expected a soft landing. But last week’s unexpectedly weak jobs report (+114k new jobs), soft manufacturing activity and an uptick in the unemployment rate to 4.3% that triggered the Sahm rule (a historical pattern that implies a recession is underway)** shifted the narrative. With a soft landing no longer a sure thing, equities tumbled, bond yields fell to their lowest level since 2023 – with the market quickly pricing in over 100 bps of rate cuts by year end. Some market pundits even called for the Fed to deliver an inter-meeting rate cut to avoid tipping the economy into a recession. The point: market narratives can change quickly, but they are not always right. This has occurred many times this cycle, and it will happen again. Don’t make investment decisions based on any one indicator or number.
2. Markets are volatile | Given the strong start to the year (+15% and 31 record highs through June 30), it’s understandable that investors had grown increasingly complacent about the strength of the market. In the July consumer confidence report, 49% of investors believed that stock prices would be higher 12 months from now – the third highest level on record. While the S&P 500 is still up ~11% YTD, the price action over the last week is a reminder that volatility remains a part of the fabric of the market. And, just to add more perspective, the current drawdown is only the second 5%+ pullback this year (there are typically three to four 5% pullbacks on average), the S&P 500 has not had a 10% correction this year (the market typically experiences ~1), and the current max drawdown YTD has only been 8.5% (the average is 13.5%). The point: while sell-offs are never comfortable, this year has been fairly calm from a historical perspective. Increasing uncertainty around the economy, earnings growth, and the election are likely to keep volatility elevated in the near term.
3. Avoid panic selling | Panic selling amidst periods of volatility can be a big detriment to investors’ performance. The reason? Some of the strongest market days often immediately follow the weakest. This week was a classic example. After the S&P 500 declined 3% on Monday, it bounced back ~1% on Tuesday. The swings in Japan were even larger, where the Nikkei 225 Index fell over 12% on Monday, rebounding over 10% the following day. That is why it is important not to panic sell during volatile times. Our research shows that missing the five or ten best days of performance can significantly weigh on returns. In fact, over the last 50 years, missing the ten best trading days (most of which immediately followed sharp sell-offs), would have reduced your average return by ~1.7% (8.3% vs 6.6%). The point: do not succumb to panic-driven selling during periods of heightened volatility. Stick to your long-term plan as, historically, investors have been rewarded for staying fully invested.
4. Diversification works | The correlation between stocks and bonds has been positive for much of the last 3 years – diminishing the diversification benefits of owning bonds in a traditional 60/40 portfolio. But with the sizeable increase in interest rates following the 2021 inflation scare, bonds are behaving like bonds again. And with inflation back under control and the macro environment showing some signs of weakness, bonds have resumed their typical role of providing stability, generous income, and diversification benefits. Case in point: during the recent market rout, bonds provided much-needed ballast against equity risk. In fact, during this recent growth scare, the negative stock-bond correlation reasserted itself again, with the rolling 60-day correlation between the S&P 500 and the Barclays US Agg Bond Index moving from .5 to roughly flat. Good news for investors!
5. A few positive takeaways | While it is easy to harp on this week’s negatives, we are going to do the opposite. Here are a few positives. The U.S. took the lead with the most gold medals for the first time during this Olympics – marking the fourth consecutive Olympics with the U.S. on top. Despite the volatility, the U.S. equity market remains the strongest developed market performer YTD. And, the sharp drop in mortgage rates (lowest since April 2023) should start to support the housing market.

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