Although stock markets mostly stabilized on Tuesday after a three-day slump, investment professionals say the global rout underlines the importance of preparing for volatility.
“Don’t try to predict where the market is going, but have a strategy in place and prepare to execute that strategy when things like this happen,” Ashish Utarid, assistant vice-president of investment strategy with IG Wealth Management in Edmonton, said in an interview on Tuesday afternoon.
Here’s some insight into what happened over the past few days, what it could mean and how investors should respond.
How we got here
Calm returned on Tuesday as U.S. and Japanese stocks clawed back much of their losses. Meanwhile, the S&P/TSX composite was down 1.12% at market close on Tuesday, as it followed Monday’s global stocks rout, which unfolded during a Canadian market holiday.
The market slump “mostly started in Japan and trickled its way into North America over the last 72 hours,” Utarid said. He attributed it to “carry trade” — when investors borrow money in a market where interest rates are low, such as Japan or China, and invest it in a market where interest rates are higher.
But things took a turn when the Bank of Japan raised interest rates last week while weak U.S. economic data was driving concern of a recession in the world’s largest economy.
“So, investors, hedge funds, retail investors would borrow Japanese yen at a low interest rate and invest them into assets, bonds, stocks and other things that were paying a higher interest rate. And so that arbitrage creates an opportunity for a free return,” Utarid said. “But … there is no free lunch.”
He described the situation as a negative feedback loop: “You sell the assets, pay the loan, but you are increasing the value of the yen, which makes your trade go upside down very quickly.”
Markets unwound on Sunday night and into Monday, he said. By Tuesday, a reversal was underway.
“That doesn’t mean that the rebound will stick. It just means that this volatility is normal,” Utarid said.
John De Goey, portfolio manager with Designed Securities Ltd. in Toronto, said he wasn’t surprised by the market slump.
“I don’t know what the outcome will be. Nobody can foresee the future with reliability. But I think there’s a higher chance this could be the beginning of a major drawdown that most people in the industry aren’t prepared to acknowledge,” he said, citing high valuations and interest rates, as well as factors such as climate change and geopolitics.
Respond responsibly
Both De Goey and Utarid said investors should be cautious in the face of market volatility, but not let emotions or sudden market changes derail their plans.
“We always say a negative 10% correction could be like a normal Tuesday in equity markets,” Utarid said. “It’s very possible that that could happen based on economic releases or government policy [or] an election. Anything can drive investor sentiment.”
“But what happens then is how you respond,” he said.
Utarid recommended investors bring their asset allocation “back in line” by reviewing their portfolios and rebalancing if necessary. And while it may be tempting for investors who are sitting on a pile of cash to pounce on a downmarket opportunity, it’s important to pause and reflect on strategy.
“There’s no need to jump into the market. You can stage your investments in over time, just like any disciplined investor,” Utarid said. “We believe in sticking to that financial plan and not making knee-jerk reactions when markets are volatile.”
De Goey suggested the global rout should not spark major reactions from investors. Instead, they should ensure they’re staying consistent with their investment plan and investment policy statement.
“They should not be reactive, because what we have seen thus far at least is well within the realm of normal market behaviour,” he said. “This is nothing particularly remarkable.”
Check the optimism bias
Though markets appeared to be regaining their positions, investors shouldn’t fall victim to optimism bias, De Goey warned.
“There’s nothing wrong with being confident, but there are problems with being overconfident,” he said.
For realistic investment projections, De Goey said he refers to the FP Canada projection assumption guidelines and factors in advisory and portfolio management fees to come up with projected returns.
Utarid said his firm relies on a “ton of macro data” for its outlooks.
“Our team monitors the macro situation and then makes recommendations on asset allocation from a geographic perspective,” he said. “We leave all the security selection up to our subadvisors and the experts on the ground.”
Further, “We have our models that look at the four or five different outcomes that could happen — things stay the same, or there’s a bull case or there’s a bear case,” Utarid said. “We kind of have ranges from there.”