Market Update — Strategies for declining markets — Part II

William F. (Ted) Truscott, Chief Investment Officer
David Joy, Chief Market Strategist
Oct. 22, 2008

The current bear market has been accompanied by unprecedented levels of volatility and investor anxiety. Many developed economies around the globe may already be in recession, as liquidity in credit markets remains strained despite the massive coordinated governmental response. At times like these, a historical perspective and a closer look at some of the truisms to investing can be helpful in setting expectations as we look ahead.

Banking crises, such as the one we are experiencing now, are not without historical precedent. In fact, the International Monetary Fund has identified 124 systemic banking crises in various countries around the world since 1970. And, while at times it may seem as though the official response to the current crisis has been somewhat ad hoc, there is extensive historical precedent for the kinds of policy initiatives that have been enacted.

Everything from capital injections into the banking system, the purchase of bad debt, deposit guarantees and loan guarantees, have all been used before to varying degrees. While there are costs associated with official policy responses, their success depends on identifying the right mix of initiatives that can best address the cause of the crisis and implementing them quickly. Equity markets have just recently shown early signs of stabilization and credit markets are beginning to thaw, suggesting that the current mix of policy initiatives is beginning to work. However, it will likely take some time before conditions are back to normal.

This is not the first or last time that markets will be in decline, and this information serves as a reminder of the importance of remaining calm, sticking to a long-term plan and removing emotions from the decision-making process — even in the face of adverse and volatile market conditions.

Market history — corrections and bear markets are a fact of investing life

Markets are not built to go up indefinitely. Long-term investors must remember that market corrections and bear markets are a natural part of the market cycle and will occur from time to time. The following are a few historical facts that shed some light on past corrections and bear markets.

• By definition, a bear market occurs when declines are in excess of 20%, while a correction occurs when declines are in excess of 10%.
• By our analysis, since 1950:
• There have been 10 bear markets or one every 5.8 years. (Note: The current bear market makes 11.)
• There have been 29 corrections or one every two years. (Note: The current correction makes 30.)
• The market has finished higher in 42 of 57 years or 74% of the time.
• The average annual returns of the major U.S. asset categories from Dec. 31, 1949 through Dec. 31, 2007 is as follows:
• S&P 500 Index (price only) — 8.02%
• S&P 500 Index Total Return — 11.88%
• 30 Day T-Bill Total Return — 4.88%
• Long-term Corporate Bond — 6.26%
• Long-term Government Bond — 5.99%
• The long-term performance of the S&P 500 Index over this same timeframe also provides some additional historical information of interest, including:
• From its peak on March 24, 2000 to its trough on Oct. 9, 2002, the index fell 49% or 46% with dividends reinvested.
• From the index's March 2000 peak, it took until May 2007 to get back to even on a price-only basis (or with dividends reinvested, until October 2006), so even with the severity of the index's drop, it eventually fully recovered.
• An even more important point is that investors not properly diversified (no small cap, value, international, etc.) would have ultimately recovered their gains only to see them given up again two months later in July 2007, when the current correction began.

(Data source: RiverSource Institute)

Recessionary markets

We now believe that the U.S. economy is in a recession that likely began in September and that it will likely be of average duration, approximately 10 months. We thought it would make sense to share some data that discusses market behavior as it relates to a recession.

• Since World War II, there have been 10 recessions, with a median duration of 10 months.
• On average, market declines began approximately six months before the start of a recession and continued to decline for another five to six months after the start. They then began to rise in anticipation of the next recovery.
• The average market decline during these recessions was 22.6%, while the median decline was 17.4%. The highest decline was 46.3% in 2001 and the lowest was 6.6% in 1980.
• The current market decline, from its peak on Oct. 9, 2007 to the trough so far (Oct. 10, 2008), has seen the S&P 500 decline by 42.5% in price-only terms.
• If you look at the subsequent gains from the market lows following a recession, they have been impressive:
• After 3 months, they gained 16%.
• After 6 months, they gained 24%.
• After 12 months, they gained 32%.

(Data sources: Ned Davis, Barclays Capital)

Futility of market timing

To correctly time the markets is nearly impossible and has been the undoing of many investors, inexperienced and experienced alike. Investing for the long term requires discipline and an acceptance that markets will go both up and down. Here are some important things to consider when discussing the concept of market timing:

• Market timing requires an investor to make two correct decisions that are very difficult to make: exactly when to sell and when to buy back in.
• You must be invested in order to participate in the gains when markets recover; missing out for even a short period of time can have a dramatic effect.
• Between Aug. 4, 1988 and Sept. 2, 2008 there were 5,041 trading days (i.e., roughly 20 years of returns). Over that time, an investor who remained fully invested would have realized an average annual return of 10.33%, while:
• Missing just the 10 best trading days would reduce the average annual return to 7.75%.
• Missing just the 20 best trading days would reduce the average annual return to 5.73%.
• Missing just the 30 best trading days would reduce the average annual return to 3.94%.
• Missing just the 40 best trading days would reduce the average annual return to 2.36%.
• Missing just the 50 best trading days would reduce the average annual return to 0.92%.

• More recently, the S&P 500 rose more than 104 points or 11.6% on Oct. 13 alone, producing its biggest one-day point gain ever and the fifth-largest one-day percent gain.

• According to Dalbar, market timing and performance chasing caused individual investor mutual fund returns to badly lag behind their mutual fund benchmarks. For equity funds, individual investors earned only 3.7% vs. the benchmark of 13.2%, while fixed-income individual investors earned only 2.0% vs. the benchmark of 5.7%. For asset allocation funds, individual investors earned 3.6% compared to the benchmark of 13.2%.

(Data sources: Ned Davis, Barclays Capital)

How investors should respond

There are steps every investor can take to deal with market declines and the volatility associated with the turbulent markets of late. In certain of our discretionary portfolios, we have begun to take advantage of what appears to be compelling opportunities in both equity and fixed-income markets by increasing our exposure to both asset categories.

Here are some tips for protecting your portfolio during times of market uncertainty and decline:

• A well-structured, properly diversified portfolio is always the best defense against market volatility.
• Resist the urge to respond emotionally to market declines; instead remain focused on your long-term investment objectives. Don't let fear drive your investment decisions.
• The core of any investment portfolio should be a long-term, strategic construction, while a smaller portion can be dedicated to making tactical adjustments that may help you take advantage of opportunities and/or avoid risks.
• Create a portfolio with the highest likelihood of achieving your desired investment objective with the least amount of risk. The focus should not be on achieving the highest return, with the attendant risks and increased likelihood of failure.
• Embrace dollar-cost averaging as a method to take advantage of the opportunity to buy at lower prices during market declines.

Potential defensive maneuvers

For investors who feel they must take some defensive action in response to the current market unrest, here are some ideas to consider:

• Focus on high-quality assets represented by companies or debt issuers who are better able to withstand a recession because of their operating strength.
• In equity markets, this generally means larger companies vs. small because:
• They are generally more mature businesses, with long operating histories.
• Their earnings stream is generally more stable and predictable.
• They are more likely to pay dividends, which can lend some stability to returns.
• In the current market, they may represent the best value.
• Equity sectors like consumer staples and utilities tend to be more defensive than economically influenced sectors like technology, energy, industrials and materials.
• In bond markets, high-quality generally means higher-rated issuers whose operations will not be strained as business conditions deteriorate.
• Cash and short-duration debt instruments have very low historic volatility.
• Non-correlated assets can be particularly effective in diversifying a portfolio.

The role of financial planning:

• Ameriprise Financial believes that a client-centric financial planning model, designed to promote focus on the successful achievement of an investor's long-term objectives, is the best protection against volatility and market declines.
• A comprehensive financial plan employs many of the recommended tactics already noted, including diversification, asset allocation, dollar-cost averaging and more. This helps investors remain calm during turbulent and volatile times in the markets and helps ensure rational vs. emotional decision-making.
• Investors with a long-term plan will resist the urge to attempt to time the markets and will understand the buying opportunities that a declining market may provide.
• For investors with a plan, this is a great time to visit with their financial advisor to discuss their investment portfolio in relation to their long-term objectives, and whether adjustments to their allocations or other parts of their plan are needed.
• For investors who do not have a long-term financial plan, this is the perfect time to meet with their financial advisor to discuss their goals and dreams and the role a financial plan may have in helping make them happen.