“A time of turbulence is a dangerous time, but its greatest danger is a temptation to deny reality. But a time of turbulence is also one of great opportunity for those who can understand, accept, and exploit the new realities.” also one of great opportunity for those who can understand, accept, and exploit the new realities.” —Peter F. Drucker, PhD, Management Consultant and Educator, Managing in Turbulent Times (1980)
ARE THOSE CLOUDS ON THE HORIZON?
Logic and history strongly suggest that the United States economy will slow to the point where Gross Domestic Product (GDP) becomes negative for two consecutive quarters, heralding a recession’s official and technical start. The big question, of course, is when?
Recessions used to be common and regular occurrences, and the topic still looms in headlines, so investors may be forgiven for not remembering or appreciating that the U.S. has spent just 1% of the time in recession (two months during Covid) during the last 15-and-a-half years. To put this statistic into perspective, since the end of the Great Financial Crisis, the frequency of a recession in any given month has been about the same as that of a Category 5 hurricane making landfall somewhere in the United States (1% versus 1%).
Of course, investors are more concerned about a bear market (i.e., a peak to trough 20% drawdown) than a recession. And while the two are highly correlated, bear markets can occur independently of recessions and vice versa. So, how worried should we be about a bear market? Considering recent history, some might say that the odds are against it.
As measured by the cumulative trading days during which the S&P 500 experienced a 20% or greater drawdown, a bear market in stocks has occurred approximately 14% over the past five years, but not at all during the 2010s. True, in December 2018, there was a 19.8% decline, but by the strict definition of a bear market it does not officially count.
To that point, and definitions aside, there were days and weeks of extreme volatility. On August 8, 2011, for example, also known as “Black Monday,” the S&P 500 dropped 6.7% when Standard & Poor’s downgraded U.S. sovereign debt from AAA to AA+, the first such downgrade in U.S. history.
With memories of the Great Financial Crisis fading, and extreme volatility increasingly rare, investors must now confront an unanticipated new problem known as “recency bias.” The term refers to the fact that we all tend to think that whatever happened last week, last year, or over the previous two years, as per the performance of the S&P 500 during the past two calendar years, is somehow normal, or better still, the new normal. It was sunny today, so it will probably be sunny tomorrow, right?
Markets don’t work that way but investors can get used to a sense that indexes march inexorably higher. However, when comparing the recent 2-year S&P 500 performance to the calendarized 2-year performance since 1928, it looks strikingly obvious that the current bull market run is an outlier. (See Chart 1 below.)
With few clouds in the sky, and because we only had one trading day in 2024 with a 3% loss (August 5, 2024) and no such days in 2023, it’s relatively easy to forget that in 2022, the S&P 500 experienced four separate pullbacks of at least 10% from peak to trough. While these declines happened over multiple days or weeks, they contributed to overall volatility of the year. (See Chart 2 below.) And, by the way, a 6.7% trading day loss in the S&P 500 sounds big enough that it should have its very own name to remember it by—and while it does (“Black Monday”), that’s yet another example of recency bias in action. Ranked by the largest percent- age drops in the past 100 years, the 6.7% drop in August 2011 doesn’t even crack the top 20. Keep in mind: it never rains, but then it pours.
CLEANING UP
A 60/40 portfolio comprising 60% equities and 40% fixed income has been popular since bell-bottom pants first became fashionable. At its inception, it was embraced as a good idea because diversification is prudent, and stocks and bonds are typically negative- ly correlated. Like all other simplified investment rubrics, the 60/40 has had its share of critics because 1) it still involves some significant risk and 2) it doesn’t always work, as happened in 2022 when both stocks and bonds lost money. Also, there’s nothing magical about 60/40. Depending on one’s risk tolerance and investment objectives, there are arguments to be made for 90/10 and 10/90, and everything in between.
No matter how a portfolio is balanced among different asset classes, it’s easy for investors to lose sight of the fact that over performing and underperforming assets cause model portfolio composition to drift—in some cases, by a considerable amount. JP Morgan Asset Management illustrated the point with a hypo- thetical 60/40 portfolio with no rebalancing between 2019 and 2025. Because U.S. Growth outperformed all other categories, an initial 25% U.S. Growth allocation ballooned to 37% of the portfolio. Indeed, preoccupied investors can wake up one day to find their 60/40 has become 74/26. (See Chart 3 on next page.) There’s never a perfect moment to rebalance a portfolio, but just like filing an annual tax return, an annual portfolio rebalancing seems prudent and advisable for those who believe in good financial hygiene.
Chart Sources:
- Chart 1: gspublishing.com, January 29, 2025
- Chart 2: covenantwealthadvisors.com, December 25, 2024
- Chart 3: am.jpmorgan.com, Slide 64, January 31, 2025
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for your clients. All performance referenced is historical and is no guarantee of future results.
All indexes are unmanaged and cannot be invested into directly. The S&P 500 is a capitalization-weighted index designed to measure the performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
Economic forecasts set forth may not develop as predicted. Investing in stocks includes numerous specific risks, including potential loss of principal. Because of their narrow focus, specialty sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
Investing in foreign and emerging markets securities involves special additional risks, including currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
Municipal bonds are subject to availability and change in price. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
No strategy assures success or protects against loss. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
High-yield/junk bonds (grade BB or below) are not investment-grade securities and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. Floating rate bank loans are loans issued by below-investment-grade companies for short-term funding purposes with higher yield than short-term debt and involve risk.
Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.
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