Buyers have stepped back into the stock market, but is this recovery sustainable? Has the market put in a bottom or will it make another material move lower?
The short answer is no one knows.
Trying to time the market should not be your primary focus. Instead, choosing solid investments and adhering to a disciplined investment approach are priorities.
In a financial report titled "Likely Gains from Market Timing," well-known U.S. economist William Sharpe, after analyzing historical returns, concluded, "Attempts to time the market are not likely to produce incremental returns of more than four per cent per year over the long run."
While it may be impossible to definitively call a market bottom, here is a good contrarian indicator: Whenever market fears dominate news headlines, we may be at or close to a market bottom. This was the case last week.
On Monday, equity markets appeared to have found near-term support – at least for now. Investors will be closely monitoring economic data, which triggered the recent sell-off. The next important report will be released on Wednesday morning when U.S. inflation data is announced. As long as there are no major surprises, markets may continue to hold their ground and volatility may ease.
Yet, investors are not out of the woods. This market volatility may persist in 2018. Investors may have to adjust their investment strategies to account for choppier market conditions going forward.
Looking back, in 2017, daily stock market moves were relatively steady without any major explosive actions. Consequently, the VIX Index, also known as a "fear gauge," hovered between roughly 10 and 15 for most of the year. To put this in perspective, generally, investors do not take serious note until the VIX spikes above 20. 2017 may have been the calm before the storm or storms.
While corporate earnings are strong, it is macro-economic conditions that are concerning investors. Interest rates are expected to steadily rise, there are growing U.S. deficit concerns, and stocks are not cheap, trading at relatively fair to high valuations. As a result, heightened market volatility may be the new norm for 2018. Any large divergences from expectations in economic releases and stocks may become vulnerable to more sell-offs.
If we are entering a period of greater market volatility, here are three investment strategies that may help investors successfully navigate through potential market spikes and drops.
Risk controls become increasingly important during times of market volatility. After the recent pullback, this may be an ideal time for investors to reassess their risk tolerance. As a general rule, within a portfolio, diversify your sector weights by owning stocks with different industry exposures. In addition, on a stock level, monitor individual stock weights with the objective of holding a portfolio that is evenly balanced with no particular stock or stocks dominating your portfolio.
For investors with a higher risk tolerance, limit the number of "seeds you plant." That is, if you want to invest in companies that are more speculative in nature, limit the weightings.
Stick with the Generals
When markets collapse, the Generals, or high quality stocks, are often the last stocks to come under pressure. Investors are reluctant to sell companies that are delivering solid earnings and dividend growth, so they do not come under the same selling pressure compared to lower quality stocks. Stocks with poor fundamentals are often the hardest hit during times of market weakness. Furthermore, after a market meltdown, it's the Generals that are the leaders. These are the first stocks to recover. Nervous investors will return to the market by purchasing stocks with strong fundamentals.
Remove the emotion from investing
As investment mogul Warren Buffet said, "If you're emotional about an investment, you are not going to do well. You may have all these feelings about the stock but the stock has no feelings about you."
In other words, if there is a negative change in the fundamentals for a company that is not a temporary or one-time event – reassess the investment thesis and if need be, sell the stock and move on. You must have confidence in all your investment positions, based on facts not hope, that they will each contribute to your investment objectives.
Pullbacks and corrections enable investors to accumulate shares of quality companies at lower prices. While the uncertainty and portfolio losses may be stressful, keeping a long-term perspective, and implementing and adhering to your risk controls can help you achieve your return objectives.