Good Riddance to Red October
By John Owens CFP®, EA, ECA, CPWA®
I moved to Lancaster, PA almost 2-years ago - much in the heart of Philadelphia Phillies fan territory. And if you’ve followed their playoff runs the last couple of years - you may have heard the term Red October - a callback to the Tom Clancy Soviet submarine spy drama of the 1980s that eventually became a movie. But the real Red October this year came from the market’s latest dose of volatility.
The month saw most major asset classes decline substantially, with US Small Cap stocks declining nearly 8%, and REITs dropping almost 5%, and International stocks giving up over 4% of its year-to-date gains. Aside from cash, every major asset class dropped during October, bringing down the year-to-date returns for many diversified portfolios to flat or rather modest 2023 gains.
Looking longer-term - most major asset classes have struggled not just in red October, but for the better part of the last 2+ years.
Looking at the MSCI ACWI - a benchmark for the global stock market - the past 24- months has produced a near 15% decline.
Fear not, right? Surely if stocks were down during those 2 years, bonds must have done well, right? Nope, the Bloomberg US Aggregate Bond Market Index dropped over 15% in that same time period.
And Bitcoin? Down 43% in the past 2-years.
How about real estate - REITs? Down 31%.
What about those booming IPOs of 2020 and 2021? The Renaissance Capital IPO index - dropped 57%.
Not the most cheerful blog post, eh? Red October will do that to you.
But it begs the question - is TODAY a good day to be invested in the market? If you’re a long-term investor, the answer is a rather resounding yes - if history is any indication. Let’s explore why that might be the case.
Valuations
Now, nobody goes to the grocery store, sees their favorite snack on sale, and says, “I don’t know if I want that.” But we feel a bit different regarding our portfolio - that’s part of the psychology of risk aversion.
This chart, courtesy of the JP Morgan Guide to the Markets, takes a look at major asset classes and how they’re valued relative to both the most recent market peak around year-end 2021 and their 25-year average.
The first consolation is that every asset class is cheaper - some significantly so than what it was at that market peak. This is typically a good sign for forward-looking returns. But it doesn’t necessarily indicate a ‘sale’. If we used to buy gas for $2.50/gallon and saw it hit $5/gallon, we can be happy that it dropped back to $4.50 and still yearn for the more affordable days gone by.
But the valuations tell us something else - they tell us that several major asset classes are not only at a discount to their 2021 peaks - which isn’t surprising - but also to their long-term average.
(Nerd alert: quick refresher for those who didn’t tutor stats in college - a Z-score is essentially the number of standard deviations an asset class is from that 25-year average valuation. So a z-score of -1 indicates an asset class is one total standard deviation from that long-term average).
So, looking at these valuation metrics - we see that 7 of 10 major asset classes are trading at a valuation discount relative to their long-term average, that US large cap stocks are trading nearly in-line with their long-term average valuation, and that US growth stocks are trading about a half standard deviation above their long-term average.
What does this mean? Coming out of Red October, it’s historically translated to a green flag in forward-looking returns for long-term investors because valuations are often better indicators of long-term performance than short-term.
Yields
One of the other tantrums the market had in recent months - especially in red October - was a freak-out about yields. 10-year treasury yields topped 5% at one point and ended the month at 4.92%. This means you can lend money “risk-free” for almost 5% interest over 10 years (risk-free is in quotes because every investment has SOME sort of risk - the risk-free nature of treasuries is that the full faith and credit of the US government backs them). A higher risk-free rate drives down future expected returns in the stock market - and increases the premiums we want from equity investments.
But higher yields on bond investments are NOT necessarily a bad thing - contrary to recent market tantrums. They mean that your cash and short-term investments can earn interest above inflation and generate real returns - something we haven’t seen lately.
And it also means that should the economy slip into recession - the Fed has tools in its monetary toolbox to cut rates and stimulate the economy. In the current political environment - where it takes 3-weeks to decide who can hold the gavel in Congress - a Federal Reserve with dry powder helps me sleep at night because we can’t count on stimulus if the shit hits the fan.
Healthy Economic Data
I will beat this drum until the cows come home - which, again, isn’t an unreasonable expectation from the guy here in Lancaster. But despite the headlines - our economy overall is not in a terrible place. Let’s highlight a few reasons why:
GDP data for Q3 came in higher than expected at 4.9% - showing the economy continues to grow despite COVID stimulus wearing off.
The unemployment rate remains incredibly low at 3.8%.
Wage growth is sitting at 4.3%, despite falling inflation, helping workers translate pay bumps into real growth in income.
And the headline Consumer Price Index was at 3.7% in September - above the Fed’s target of 2% inflation - but below 50-year average of 3.9% - showing that inflation continues to get under control.
Again, these are green flags when you filter out the noise of red October.
So, we’re all good, nothing to worry about?
No. Probably not. Definitely not. There are still factors that can throw the market - and our global economy for a loop. There’s a continued war in Ukraine and a new war in the Middle East. There are threats of aggression from China into Taiwan; and fear that world powers may be drawn into conflict in the Middle East - not only a tragedy and economic drag - but something that could also cause a shock to oil markets.
There is what I’d generously describe as a dysfunctional and divided government in the United States that still needs to figure out how to fund itself and pass a budget - in a mere few weeks.
And when you look out on the horizon, there’s a US election that is increasingly looking like a rematch between two politicians whose age makes them more likely to be running for the Condo board at Del Boca Vista in a Seinfeld episode than to be the leader of the free world.
That said, all is not lost.
It’s important to remember that there have ALWAYS been scary headlines on the horizon. The devastating fighting in Israel and Gaza has sadly been a story played out now for generations. The hyperbolic divisiveness of our political system has been amplified by social media and our 24-hour news cycle - but it is not new. World superpowers have and always will angle for more might, influence, and scale - with the bad actors doing so in ways that infringe on the sovereignty of others.
So, the question I set out to answer in this post is whether TODAY is a good day to invest in the market. After Red October. Amid volatility. With geopolitical dangers both near and far. And when we filter out the noise and look at the data - valuations, yields, and the economy overall - a long-term investor ought to feel good about being invested today. There is a sale going on in the markets. There is, what has been seemingly rare, a yield and upside in the bond markets. And there are positive economic indicators that could be the sunshine that helps drive storm clouds of heavy headlines away.
As we say good riddance to Red October, let’s keep our eye on the prize - the long-term, the upside that’s out there, and how we control what we can - and try not to overreact to the rest.