One fear many investors have is incurring a large drop in the stock market. “Major drawdowns,” as defined by AQR Capital Management, are those where prices drop by at least 20% from peak to trough. The investment firm counts 11 such drops as having occurred in the stock market since 1926, or about one per decade.

Though stock prices have fully recovered within 27 months, on average, according to AQR’s data, realizing the recovery requires an investor to stay fully invested in stocks. This is something that’s much easier said than done. Various studies show a tendency to pull out of stocks when their prices are down. Even if someone sticks with their allocation to stocks, the drops can be painful. Major drawdowns can even be problematic from a timing standpoint, especially for those who had the unfortunate luck of reporting shortly before the drop occurred.

There is a simple solution for cushioning against the blow of such drops: diversify. Holding assets whose returns are affected by different risks than stocks lessens the impact drawdowns have on portfolio wealth. However, diversification can come at the cost of lower long-term returns, as an analysis from AQR shows.

Among the diversifiers looked at were 10-year U.S. government bonds (e.g., Treasuries). These are uncorrelated to stocks and have, on average, experienced positive returns during major drawdowns for stocks. A basket of commodities is comparatively more correlated to stocks than bonds but has historically had low correlations with stocks. Commodities do have higher long-term average returns than bonds, but with far longer tails. In other words, bonds offer better odds of cushioning the blow, while commodities offer greater average upside albeit with much larger upside and downside returns. (Expenses do not appear to have been factored into AQR’s data.)

Cash can also be used to diversify. Just moving 10% of the equity allocation into stocks has historically led to 2.8% better drawdown returns. While this may sound enticing, the trade-off is a 0.8% reduction in long-term returns. As is the case with bonds and commodities, the price of easing short-term pain is less long-term wealth.

What about other sources of protection? AQR looked at a few, the easiest to understand being gold and puts. Since 1986 (a short time period for this type of analysis), including an allocation to gold has led to positive returns during stock market drops of at least 10%, at the cost of lower average returns. Puts—options that allow the contract holder to sell at a preset price—have good defensive properties but lead to negative long-term returns. (Various factors affect the actual return of a put strategy, but AQR’s findings should serve as a warning sign in regard to continuously holding onto puts.)

As far as timing the market is concerned, it’s harder than it looks. AQR looked at the drawdowns relative to Yale professor Robert Shiller’s CAPE (cyclically adjusted price-earnings) ratio. They found no consistent patterns between the level of the long-term valuation indicator and when drawdowns occur. More so, stocks tended to continue to rise when the markets were “very expensive.” Such increases occurred “more than half of the time.” (To be fair, AQR is not completely opposed to making small tactical tilts based on valuation or momentum indicators but have suggested investors just “sin a little.”)

The only way to truly protect against stock market drops is to not be in the stock market. Hedges, such as puts, do pay off during drops, but the stock market rises far more than it falls; most calendar months have positive average monthly returns. Diversifying into uncorrelated assets, such as bonds, reduces the volatility of an all-stock portfolio, but at the cost of lower long-term returns.

• The Importance of Diversification in Retirement Portfolios – Including small-cap stocks and Treasury bills can enable a retiree to take larger withdrawals.
• The Permanent Portfolio: Using Allocation to Build and Protect Wealth – This alternative allocation adds cash and gold to a traditional stock/bond portfolio.

• Simplified Expectations for Normal Investors – Focusing on four foundational elements—growth, pain, fit and flexibility—can help to establish reasonable expectations about potential outcomes.
• Model Shadow Stock Portfolio: Why Quarterly Reviews Still Make Sense – The higher costs associated with the purchase and sale of less actively traded stocks make it more profitable to transact less frequently.

Monday is Columbus Day, which is a federal holiday. As such, the bond markets will be closed. The U.S. stock exchanges will, however, operate on normal hours.

Third-quarter earnings season will begin in earnest with eight S&P 500 index companies scheduled to report. Included in this group are Dow Jones industrial components Walgreens Boots Alliance Inc. (WBA) and JPMorgan Chase & Co. (JPM), which will report on Thursday and Friday, respectively.

The week’s first economic report will be the September producer price index (PPI) released on Wednesday. Thursday will feature the September consumer price index (CPI). September import and export prices and the University of Michigan’s preliminary October consumer sentiment survey will be released on Friday.

Three Federal Reserve officials will make public appearances: Chicago president Charles Evans on Tuesday, Wednesday and Friday; New York president John Williams on Wednesday; and Atlanta president Raphael Bostic on Wednesday and Friday.

The Treasury Department will auction $36 billion of three-year notes on Wednesday, $23 billion of 10-year notes on Wednesday and $15 billion of 30-year bonds on Thursday.

Optimism among individual investors about the short-term direction of the stock market is at its highest level in eight months according to the latest AAII Sentiment Survey. Both neutral and bearish sentiment pulled back below their historical averages.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 9.4 percentage points to 45.7%. Optimism was last higher on February 14, 2018 (48.5%). The increase puts bullish sentiment above its historical average of 38.5% for the first time in four weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 3.5 percentage points to 29.2%. Neutral sentiment was last lower on July 11, 2018 (27.8%). This is just the second time in 33 weeks that neutral sentiment is below its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 6.0 percentage points to 25.1%. This is a five-week low. It is also the first time pessimism is below its historical average of 30.5% in four weeks.

At current levels, all three indicators are within their typical historical ranges.

This week’s results put bullish sentiment at its fifth-highest level of the year. Since the end of February, optimism has only been above average nine times. It has not stayed above average for a span of more than three consecutive weeks since January.

Tariffs and the possibility of an escalating trade war remain front and center on the minds of many individual investors. Also influencing sentiment are Washington politics (including President Donald Trump), midterm elections, economic growth, valuations and corporate profits. The record highs in the Dow Jones industrial average likely gave encouragement to some individual investors, but not all.

This week’s special question asked AAII members for their opinion on the Federal Reserve’s ongoing course of raising interest rates. Nearly three-quarters of respondents (73%) think the Fed is doing the right thing by raising rates. The overwhelming majority of these respondents favor gradual rate hikes. Others in this group of respondents believe that the Fed needs to keep raising rates to keep inflation in check or otherwise view the hikes as being overdue.

Almost 20% of all respondents expressed concern about the ongoing rate hikes. Some of these respondents believe the Fed is being too aggressive, while others expressed concern about the hikes causing a correction.

Here is a sampling of the responses:

• “They have to raise from zero so that they have a tool against a recession, inflation, etc. As long as the raises are small and gradual, I see no harm.”
• “I think it’s good; interest rates need to be above the inflation rate and high enough for reduction when the economy weakens.”
• “Let it be stable for a few quarters. I don’t want it to stunt growth.”
• “I’m concerned about raising rates too quickly. They need to keep a very close watch on the economy and adjust their policy as needed.”
• “It is about time. I am happy to see the improved interest in cash accounts.”

Bullish: 45.7%, up 9.4 points
Neutral: 29.2%, down 3.5 points
Bearish: 25.1%, down 6.0 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Individual investors’ exposure to equities reached a four-month high last month. The September AAII Asset Allocation Survey also shows declines in fixed-income and cash allocations.

Stock and stock fund allocations rose 1.4 percentage points to 69.9%. This is the highest level since May 2018 (70.0%). September was the 66th consecutive month with equity allocations above their historical average of 61.0%.

Bond and bond fund allocations were a very modest 0.2 percentage points lower at 14.2%. Fixed-income exposure was last lower in May 2018 (14.1%). Last month was also the 10th consecutive month with bond and bond fund allocations below their historical average of 16.0%.

Cash allocations declined 1.1% to 16.0%, nearly reversing August’s increase. Cash allocations remain below their historical average of 23.0% for the 82nd consecutive month.

A good month for stocks (particularly larger-capitalization stocks) combined with a rising yield for the 10-year Treasury note did little to sway individual investors’ allocations. So far, tariffs have not altered how the majority of individual investors are allocating their portfolio. At the same time, optimism about the stock market’s short-term direction mostly stayed below average during September in our weekly Sentiment Survey.

Last month’s allocation levels were within the range we’ve seen throughout the year, even though equity allocations did trend up from summer levels. There wasn’t much in terms of movement among the major financial market indicators to drive allocations in one direction or another in September. While optimism was mostly below average in our Sentiment Survey, pessimism was just slightly above its historical average.

Last month’s special question asked AAII members if trade policy has affected their allocations. More than three-fifths of all respondents (63%) say trade policy has not altered how they allocate their portfolios. Several of these respondents say they expect disputes to be resolved, while many others describe themselves as long-term investors. A smaller portion of these respondents explain that while trade tensions have not influenced their allocation decisions so far, they potentially could have an impact in the future. Almost 15% of all respondents say they have increased their cash allocations or otherwise have become more conservative because of trade policy. About 8% of all respondents have either sold or are postponing the purchase of foreign stocks.

Here is a sampling of the responses:

• “Trade policy has not impacted my allocation. I am a long-term investor; it’s impossible to determine what actual changes, if any, will occur to trade policy.”
• “Trade tensions have caused me to increase my cash position in anticipation of market volatility.”
• “Has not; I do not react to short-term events. In the long term, these trade policies have a way of resolving themselves.”
• “So far, trade policy has not influenced my investment strategy, but I am watching.”
• “I’m staying away from international exchange-traded funds (ETFs).”

• Stocks and stock funds: 69.9%, down 1.4 percentage points
• Bonds and bond funds: 14.2%, down 0.2 percentage points
• Cash: 16.0%, down 1.1 percentage points

• Stocks: 33.9%, up 3.0 percentage points
• Stock funds: 36.0%, down 1.6 percentage points
• Bonds: 2.7%, down 0.1 percentage points
• Bond funds: 11.4%, down 0.1 percentage points

Take the Asset Allocation Survey.

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