November 2024 Market Commentary

November 2024 Commentary

As we approach the end of 2024, there are a myriad of reasons to be skittish about the market. The S&P500 has returned 52.77% over the last 22 months (through 10/31/2024) – valuations are high. A single name, Nvidia, constitutes 17% of the risk of the S&P 500, and risk concentration is at highs not seen since the Dot-Com Bubble. Republicans will control the White House and possibly both the House and Senate in January 2025 so there’s potential for significant policy change. War continues in Gaza and Russia is massing a new offensive against Ukraine; geopolitical risk remains high. During periods of heightened uncertainty, investors are often hesitant to commit capital, preferring to wait for a sell-off or wait for risk to subside. Unfortunately, in some cases, the sell-off never materializes and the path forward never becomes perfectly clear. Oftentimes in this scenario, the fear of committing capital comes at a significant opportunity cost. Being out of the market may avoid large losses, but it also risks missing out on significant upside as well. Concern about market risk is understandable, but the right question may be: Is being out of the market the real risk to long-term investing success?

What do Investors Fear?

If we look at the way retail portfolios are often described, it’s no wonder investors are nervous during periods of heightened uncertainty. Terms like “Aggressive” suggest higher risk but really don’t give an investor much of a framework for determining how their portfolio might behave in a crisis. Statistical descriptions like “9.0% expected return with 14% volatility” are also of little use when uncertainty is high. Most investors simply want to know, “How bad could it be?” A response might be “At the 95% confidence interval your portfolio will not lose more than 37%.” The use of percentiles and confidence intervals is often confusing and leaves the investor no better prepared to make a decision during uncertainty. To answer the question “How bad could it be?” let’s answer the question directly using the maximum observed loss or peak-to-trough drawdown.

Maximum Observed Loss

Maximum observed loss or peak-to-trough drawdown is simply the maximum loss a portfolio has incurred based on historical data. This metric isn’t based on a statistical distribution and isn’t restricted to one month, one year, or any time horizon. It simply answers the question “Based on history, what’s the most money that a portfolio lost before regaining the level of the initial investment?” To illustrate this concept let’s look at the peak-to-trough drawdown of a common equity benchmark, the S&P500.

Exhibit 1

Source: Bloomberg, AAFMAA Wealth Management & Trust

Exhibit 1 shows the cumulative return of the S&P 500 from the beginning of the Great Financial Crisis. This was the period that corresponded to the maximum observed loss over the past 30 years. In this case, the peak-to-trough drawdown began in November 2007, the point of maximum loss (-50.95%) occurred at the end of February 2009, and the portfolio recovered 100% of its original value by the end of March 2012. It took approximately 4 years and 5 months to recover 100% of portfolio losses. This is a daunting loss and without context would likely drive an investor towards a less risky portfolio. Let’s look at the peak-to-trough drawdowns across a range of portfolios of varying risk.

Exhibit 2

Source: Bloomberg, AAFMAA Wealth Management & Trust

Exhibit 2 shows the worst peak-to-trough drawdowns for various combinations of equity (S&P 500) and fixed-income (Bloomberg Intermediate Government/Corporate). Indeed, the peak-to-trough drawdowns are reduced significantly by adding increasing amounts of fixed-income exposure. If an investor were only shown the worst losses for a series of portfolios, he or she would likely choose the portfolio with the lowest loss. However, as investors, we know that there is a link between risk and return. So what is the opportunity cost of selecting the portfolio with the lowest drawdown?

Long-Term Impact of Investing Prior to a Major Drawdown

In the previous section we saw that if we invested in the S&P 500 on November 1, 2007, we would have invested at the beginning of the worst drawdown in the last 30 years. The magnitude of that drawdown can be reduced by reducing equity exposure and adding fixed-income exposure, but we don’t know the opportunity cost. Exhibit 3 shows the cumulative returns of our suite of portfolios from 11/1/2007 through 10/31/2024.

Exhibit 3

Source: Bloomberg, AAFMAA Wealth Management & Trust

Exhibit 3 shows that the 100% S&P 500 portfolio, the portfolio with the largest maximum loss, recovers all of its losses at the four-year and five-month mark. By September 2014, the cumulative return of the 100% S&P 500 portfolio exceeds all of the less risky portfolios, and by October 2024 it exceeds the 80/20 portfolio by 94% and is more than six times the return of the 100% bond portfolio. So, in this case, investors who had a 10-year or longer time horizon and remained in the largest drawdown portfolio still substantially outperformed less risky portfolios even after investing just before the largest drawdown in the last 30 years. Even in this scenario, the cost of not being fully invested in the equity market was substantial.

A Closer Look at Drawdown Periods

If we take a closer look at the last 30 years and examine periods where market drawdowns were in the 20% or more range, we will see some similarities. In many cases, the drawdowns were driven by unforeseen events, e.g. the September 11^th attacks, the Great Financial Crisis, and the onset of COVID. When these unforeseen events occur, the market often sells off violently as the true market impact of the event isn’t well understood. As investors have time to process the government response and the economic impact of the event, market expectations are sometimes revised upward significantly relative to the lowest point of the drawdown. The result is that many drawdowns are V-shaped, that is the loss is significant, but it is fully recovered in a very short period. Exhibit 4 shows a graph of the cumulative return of the S&P 500 after the COVID-related market drawdown that began in early 2020 (the first documented case of COVID was in November 2019 but the sell-off did not begin until January 2020).

Exhibit 4

Source: Bloomberg, AAFMAA Wealth Management & Trust

In this case, the S&P 500 began to decline in January 2020 and reached its maximum drawdown (-19.6%) in March 2020. Amazingly, the losses associated with this drawdown were more than fully recovered by July of the same year (the drawdown lasted only seven months).

The fact that many of the largest drawdowns were driven by unforeseen events suggests that trying to reduce market exposure prior to such events is difficult, to say the least. Additionally, the V-shaped nature of the recoveries suggests an additional problem: even if an investor avoids the initial drawdown, how does the investor know when to reenter the market? Some of the historically largest return months for the S&P 500 occurred during the recovery periods after large drawdowns. To give some perspective to the impact of being out of the market, Exhibit 5 shows the difference in cumulative returns of the S&P 500 over the last 30 years versus the cumulative returns of the S&P 500 minus the 10 largest monthly returns. The long-term impact is significant with the cumulative returns differing by more than 1300%.

Exhibit 5

Source: Bloomberg, AAFMAA Wealth Management & Trust

It is startling that we are talking about only 10 months out of 370 months. If the portfolio is only uninvested for the 10 months with the largest returns, the decline in cumulative return is dramatic. Major market upswings often happen over very short time horizons; it’s critical to long-term performance to be invested during those periods.

Conclusion

As we head into 2025, there are many reasons to be concerned about the market; there almost always are reasons to be hesitant about investing. But as we’ve seen, large drawdowns are often driven by unforeseeable events. Even if we had information that allowed us to miss some of the drawdowns, deciding when to reenter the market is an important decision, and missing large positive returns can be more damaging to long-term success than failing to avoid negative ones. History suggests that if we truly are long-term investors with a time horizon of 10 years or more, then avoiding the big drawdowns is not critical to our long-term financial success. Exhibit 6 levels the playing field a bit and looks at not only the peak-to-trough drawdowns of our suite of portfolios but also the cumulative return of the portfolios over the last 30 years.

Exhibit 6

Source: Bloomberg, AAFMAA Wealth Management & Trust

When constructing a portfolio, consider your time horizon and potential drawdown as well as potential long-term cumulative return. When an investor’s time horizon is 10 years or longer, being out of the equity market can be a substantial risk.

Yours in trust,

Parker

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© 2024 AAFMAA Wealth Management & Trust LLC. Information provided by AAFMAA Wealth Management & Trust LLC is not intended to be tax or legal advice. Nothing contained in this communication should be interpreted as such. We encourage you to seek guidance from your tax or legal advisor. Past performance does not guarantee future results. Investments are not FDIC or SIPC insured, are not deposits, nor are they insured by, issued by, or guaranteed by obligations of any government agency or any bank, and they involve risk including possible loss of principal. No information provided herein is intended as personal investment advice or financial recommendation and should not be interpreted as such. The information provided reflects the general views of AAFMAA Wealth Management and Trust LLC but may not reflect client recommendations, investment strategies, or performance. Current and future financial environments may not reflect those illustrated here. Views of AAFMAA Wealth Management & Trust LLC may change based on new information or considerations.