Markets at War – Investing in times of volatility

Mark Armbruster, CFA
Armbruster Capital Management

We wrote in our last newsletter that increased stock market volatility is likely as we look ahead. We had no special knowledge at the time of what is now unfolding in the Ukraine. However, a confluence of factors, including “geopolitical risk” made it likely that the market would be less stable in the future. 

Unfortunately, we were correct. The Russian invasion of the Ukraine has roiled markets as economists and strategists try to parse the likely impact to the global economy. Again, we don’t have any more information than anyone else on this score, but we can look to history as a guide.

We wrote an article for the CFA Institute back in 2013 on what has happened to the stock market during periods when America was at war. While we’re not technically at war today, we thought it would be interesting to revisit the data. The numbers from our original study are presented in the table below, but the punchline is that the stock market has generated returns above historical averages and with less risk during periods of war.

This may seem counterintuitive since war creates uncertainty. However, after an initial knee-jerk reaction to the outbreak of a war, the market seems to accept the “new normal”. That is not to discount the very real impact of wars, only to show that they are often not the only or even the dominant consideration in stock market returns. After the initial impact is digested, economic fundamentals seem to take over and become the primary factors driving the returns and volatility of the stock market.

That’s the good news. The bad news is that the economic fundamentals aren’t so great these days. We’re still facing fairly high domestic stock market valuations, rising interest rates, high inflation, and massive federal debt. There are offsets that are helping to prop up stocks, such as loads of liquidity thanks to loose monetary and fiscal policy in the recent past, as well as a record number of stock buybacks by corporations.

No one knows what will happen to the stock market in the near term, and it is fairly easy to paint both bull and bear cases. However, it seems all but certain that longer-term returns will be lower than what we have grown accustomed to.

High valuations and rising interest rates are not a recipe for continued returns the magnitude of which we experienced over the past decade. That doesn’t mean we should head for the hills, only that we need to start to anticipate lower future returns for a while. Ten years may seem like a long time, and it will seem exceptionally long if we have another “lost decade” for stocks, but most of us and our portfolios have time horizons that stretch far beyond that. So, a long-term investment approach still makes sense even if the intermediate term is less bright than we would like.

There are also upsides to stock market downturns, should we experience a protracted period of malaise. They allow us to rebalance portfolios and lock in tax-efficiencies that can carry forward for many years. They also allow entry points for those sitting on cash or averaging into the market.

Tax-loss harvesting is the biggest of these benefits. We sell stocks that have declined in value, and immediately repurchase similar stocks. This keeps your portfolio fully invested but realizes losses for tax purposes that can be used in the future to offset realized capital gains and a modest amount of ordinary income. Such selling is a big component of our tax-efficient investing strategy.

Uncertainty in the stock market and losing money on your investments, even if only temporarily, is never fun. However, risk is part of the investment experience. Without it, there could be no reward. We have no idea where stocks will settle in the near term, but significant further declines would not be surprising. It can be hard to ride through these periods, but decades of evidence suggest that is the right thing to do.

If you would like to chat about any of this, or your specific investments, feel free to call us any time.