Jason Stipp: I'm Jason Stipp for Morningstar. Stocks suffered their biggest weekly loss in about two years last week after what has been a pretty tremendous rally in the market.
Here to talk about what the volatility means for investors is Morningstar markets editor Jeremy Glaser and our director of personal finance, Christine Benz.
Thanks for joining me.
Christine Benz: Great to be here.
Jeremy Glaser: You're welcome, Jason.
Stipp: Jeremy, anytime the market moves dramatically like this, investors want to know what's behind it, what caused it. In this case there seem to be almost as many answers as there are commentators.
Glaser: I think that's right, and it's hard to point any one item really giving a satisfactory answer as to why the markets sold off so much last week.
One that's talked about a lot is the future of Federal Reserve policy. I think it's understandable why this is on investors' minds. We've had unprecedented policy in terms of the Fed's quantitative easing programs, in terms of their new, very open communication policies compared to the past. And I think investors really just don't know what that's going to look like when that exit begins. We just don't have a good roadmap there.
But nothing that we saw over the last week radically changes what we should be expecting from the Fed. We heard from the rate decision that the taper is on track and should end reasonably soon--they should stop adding to their balance sheet--and that rates could rise sometime next year. These are both things that we had expected going into the week, and given the economic data that we got last week, with GDP for the first half of the year growing at about 2%, I don't think there is any reason to think [the Fed's plans are] going to change. So it's hard to see the Federal Reserve alone being responsible for such a big sell-off.
Stipp: What about some of the geopolitical issues that we've seen? Argentina was in the news last week, continued news out of Europe. Could that have been behind some of this market sell-off?
Glaser: I think that probably contributed as well. But it's hard to say that any one is the major factor behind what we saw last week.
Argentina's default is the result of a court case that's been going on for quite some time now. They may still be able to reach a resolution. It doesn't seem like the market is overly worried about the global consequences of that right now.
Certainly, people have been worried about the capital levels of European banks for some time, but again, nothing terribly new coming out there--no new worries and certainly nothing like the 2011 eurozone worries before.
You have to look at the conflict in Israel and Gaza and in the Ukraine as also weighing on investors' minds. But those are also conflicts that have been going on for some time. It's hard to see what really precipitated last week's sell-off.
I think the answer may be simply that stocks have gotten overvalued, and when stocks are priced for perfection or more, and there are any signs that anything could go wrong, it is an excuse to sell, it is an excuse to take some profits. That may be the simplest explanation.
Stipp: Christine, we know that investors feel the pain of losses more acutely than they get pleasure from their portfolios going up. But that said, we've had a long period where our portfolios have been performing quite strongly. So it's important for investors not to forget that.
Benz: Right. With the exception of a few lousy periods, like the summer of 2011, it's been an extraordinarily placid period for stock investors. And I think that investors really would do well to look upon their portfolios' gains over the past five years and just see how very strong they've been.
When we look at the nine equity style box based categories, we see a 15% annualized return over the past five years; that's just a tremendous run.
Even year-to-date, six of the nine domestic-equity style box categories have had positive returns, even counting in this recent bit of market volatility.
So, unless you had a portfolio that was heavily skewed toward small caps--which have performed not so well this year and have in fact had losses--chances are you probably are still in the black with your equity portfolio so far in 2014.
Stipp: People who were seeing this market sell-off, and thinking, I've got to stop the bleeding, they should step back for a moment and realize if they had been in the market, they probably haven't seen any bleeding over those longer time periods.
Benz: Exactly, and if they had been in the market is really the big statement here, because there were unfortunately a lot of investors who weren't fully in the market at the beginning of this current equity market rally. But those who were, those who did hang on to stocks, have seen very nice gains, and even those who managed to just hop aboard in time for 2013 have seen very nice gains.
Stipp: Jeremy, our stock analysts have written in their last few quarterly updates about the market looking fully to overvalued. Has this sell-off done anything to make valuations overall look more attractive?
Glaser: It hasn't. This has not created giant pockets of opportunity. There still are a few, but generally speaking, stocks are about 1% overvalued, so the median stock that our analysts cover is trading at 1% above it's fair value estimate. This is a little bit less expensive than it was at the beginning of last week, but not dramatically so. And it's really a far cry from, say, the summer of 2011, where stocks were 18%-19% undervalued, or even if you go back to 2008, and you see that 50% undervaluation. We're not seeing huge areas that are undervalued.
Stipp: So, given that stocks still are, in some cases, even a little bit overvalued, we could see a little bit more sell-off and maybe not be overly concerned that valuations are now depressed?
Glaser: I think that's right.
Stipp: Christine, from a portfolio perspective, when you see the markets move like this, what are some of the implications when you look under the hood at your asset allocation, and how you've managed your portfolio?
Benz: I think Jeremy made a really important point about where equity market valuations are, and I think for most investors, the best idea is not to try to second guess their positioning by doing a lot of market-timing, but instead look to setting a strategic asset allocation and then periodically making sure that they are in line with that asset allocation.
Investors who have been very hands off over the past couple of years probably would look upon their asset allocation and find that even with this recent market volatility, they are much heavier in equities than they intended to be. So I think rebalancing still makes sense, stripping back from equity holdings, getting back in line with your target. If you are another year closer to retirement, you may want to get even more conservative still. So, revisit your current asset allocation, use our X-Ray tool to get a finely tuned view of your stock/bond mix, and see if some changes might be in order.
I think it also makes sense to dig a little bit deeper, even intra-asset class, to see whether some rebalancing might be in order. Even though small-cap stocks have sold off so far in 2014, they still have had a tremendous run relative to large-cap stocks, so you may need to do a little bit of trimming there, even though the market has done some of that work for you within equities.
Also take a second look at some of the more defensive holdings in your portfolio. They may not look especially great in terms of relative returns over the past five years, but chances are you want them in your portfolio; you want something that will be a little bit more defensive that will hold up well during these periodic bouts of volatility.
Within fixed income, also take a look at your exposures. We've seen a tremendous runup in some of the more credit-sensitive bond types. High-yield bonds in particular have had a tremendous run. The typical high-yield fund has returned something like 11% over the past five years on an annualized basis. The typical core-type intermediate-term bond fund has returned just 5%.
So if you've been hands-off, if you've been doing nothing, or maybe you've been adding to high-yield, chances are you are a little more credit-sensitive in your fixed-income exposure than perhaps you intended.
Stipp: And these market hiccups can be valuable, as well, in what they tell us about how diversified we are. What might my experience have been if I wasn't as diversified as I should've been after this market hiccup?
Benz: Well, you absolutely want to have something in your portfolio that performed well over the past week, or at least held its ground and did not lose money. So take a look at that, do that mini-stress test to see, did all of my holdings go down in lockstep, or did I have some things that held their ground or even maybe gained a little bit? If you had fixed income in your portfolio, that was your higher-quality fixed income exposure. We saw those bonds doing almost exactly what we want them to do in this recent period of market duress. They actually gained a little bit, or at least didn't lose money.
Stipp: Jeremy, the market overall, you said, is not looking particularly attractive. If I'm the stock investor or an opportunistic investor, what should be my next step here? What should I have my eye on?
Glaser: I think you need to look for stocks, first, with economic moats, with competitive advantages. These are stocks that are going to able to withstand what happens to market, what happens to the economy if there is a slowdown. These are stocks you're really going to want to have for the long term. And it's important to have that long-term horizon when you're buying stocks, because there can be these hiccups, and you don't want to have to sell into a down market to, say, pay college tuition or fund your retirement.
The other thing is to continue to keep an eye on valuation. Just because the market is a little bit overvalued doesn't mean that you should then just pay whatever because there aren't any values. You should still find the best relative values out there. Particularly for these high-quality companies, paying a fair price might still be a good idea.
Our analysts think there are still some stocks like that available. Amazon.com, Berkshire Hathaway, Ultra Petroleum are just three examples that our analysts think look attractive right now.
Stipp: The market took us on somewhat of an unpleasant ride over the last week. But thanks for helping us, Christine and Jeremy, to understand the situation.
Benz: Thank you, Jason.
Glaser: You're welcome, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.